This article examines the respective risks of deflation and hyperinflation. Although at first glance these two seem to be at completely opposite ends of the monetary spectrum the article explains how looming disaster brings them both within one false step of economic management, and further explains how central bankers are eventually forced into taking that step.
Inflation's relationship to the supply of money
We mostly realise how an increasing supply of money causes it to diminish in value and tends to produce rising prices. We are also dimly aware that the relationship between issuing money and rising prices feels linear, meaning that if governments issue 1% more money it will raise prices by something like 1%.
This is a logical conclusion as long as money remains the dominant medium of both storing and exchanging wealth. After all, if there is a supply of 1% more money, and the same underlying things to buy with it, then those things need to rise by 1% to use up the supply. Since there is no evidence, and little likelihood, of our governments suddenly going completely crazy and printing 1000 times the quantity of money that currently exists we assume, because of approximate linearity, that there is little or no risk of hyperinflation.
But one of the mysteries of historic hyperinflations is that price rises massively outstrip the rate at which money has been recently issued, which indicates the relationship between money supply and inflation in some circumstances is not linear. We need to understand how this happens if we are to appreciate latent hyperinflation risks.
Dollars are an attractive thing for people and businesses to own because they tend to increase purchasing power, through the receipt of interest, just through being deposited. Because dollars are attractive any loosely held ones get snaffled up. Large numbers of people and businesses compete vigorously to win loosely held dollars (the ones in the bank accounts of consumers) and as a result dollars accumulate in lots of pockets. Wherever a dollar appears in economic space there is a hungry accumulator of dollars somewhere nearby, and as long as we know everyone is competing for them we are confident that our dollars will be able to buy what we want.
A little high school science provides an analogy. Suppose a dollar is a positively charged atom existing in a world of negatively charged people. Like static electricity the people attract the dollars.
At different times, depending upon the policy mix of central bankers, the amount of positive electric charge on dollars - and hence their attractiveness - varies. This is a consequence of governments being in control of money values, as they are with all our central bank run currencies. If, like a large positive charge, dollars store and gain lots of monetary value over time, then they stick like glue in the pockets of their negatively charged owners. This sticky money does not get spent, indeed the more rapidly it increases its purchasing power the more sticky it becomes in pockets.
Overly sticky money diminishes economic activity and causes falling prices and the phenomenon of deflation, because it profits people to put off their spending for as long as possible.
Money created by central bank policy can be injected into the economy to steadily reduce the positive charge on all dollars. It achieves this by expanding the supply and decreasing the likelihood of held money increasing its purchasing power through time, and this makes it stick less in peoples' pockets. By making it less sticky governments keep it circulating. Supplying more money encourages people to spend rather than save their money, and it stimulates economic activity.
It really is quite magical how this can work. Governments can create economic activity at will simply by injecting new money to weaken the glue which binds the already issued supply in peoples' pockets. But it operates a little like a drug. It is so easy and - while it behaves linearly - appears to be so safe for such a long time that governments get to rely on it as the trusted, and sometimes only mechanism necessary for economic management. But underneath this process can gradually approach a potential hyperinflation scenario. The electric charge analogy can show us how.
As the tendency of money to increase in value merely through being held diminishes towards zero its velocity around the economy increases because people and businesses become ambivalent about holding and depositing cash. Like atoms with no charge these dollars are not attractive, so they don't settle on people. At this stage economic activity - which is measured by the rate at which these dollars are flying around - looks magnificent, but little of it is meaningful or productive. What is happening is that because money has become a poor store of value it encourages savers to trade into other assets. This is not consumption, it is financial trading, or the acquisition of things with the intention to secure wealth and make profits, and it draws attention to a currency which is starting to lose its favoured status as a store of value.
Financial trading is not supposed to be included in measurements of productive economic activity, but of course it often is. Unfortunately there is no handy statistic to prove it, so we must guess at what sort of other things we would see if this was what was happening.
Presumably we should expect to see pleasantly large economic activity statistics, yet rather poor corporate profits (unless of course they were fabricated by imaginative bookkeeping). We should also see very poor savings aggregates across the population and a tendency to accumulate debt as people started to believe that borrowings will inflate out of existence. We should also see rising prices in alternate assets - like housing - representing the fall of money's perceived value against those alternative stores of wealth, and maybe even a boom in stock prices without an underlying boom in profitability - so yields would disappear. We might even see people scratching their heads about why a recovery was producing few jobs.
If money becomes more likely to lose than gain value it is as if its charge has switched, from positive to negative. Net of the benefits and costs of holding money (e.g. interest, tax and anticipated inflation) money is suddenly expected to return a lower purchasing power in the future than it currently has.
This happens from time to time without producing a disaster. The reason is that depositors expect a negative net return on cash to precede an imminent increase in interest rates. And this is what ordinarily happens, as cheap money encourages spending and heats up the economy, which is soon cooled by a dose of higher rates which suits the savers.
This hope will encourage savers that the negative real return on their deposited cash is only temporary.
But there is a catch. The raising of rates can only be done when there is no risk of it causing debt servicing problems for large numbers of borrowers. Otherwise different risks arise. If, for example, after a long borrowing binge corporate debt is high, public debt is high, and consumer debt is high, the increase of rates (strengthening the monetary glue which keeps money in people's pockets) and the economic slowdown they should cause, now risks producing unserviceable debt and large scale default. These can destroy savings as dramatically as hyperinflation, only through its ugly sister deflation.
So Mr Greenspan, who has safely fought inflation while debt was under control, now, with private, corporate and public debt all at record levels, has to fight both hyperinflation and deflation risks at the same time. Increasing interest rates will risk deflation. So to prevent a deflation he has to hold rates low for long enough to allow a demand led recovery and an increase in general financial strength. Only then can rates rise.
The negative return on cash is now likely to get worse before it gets better, as real inflation (and taxes) outstrip any modest interest rate rises, so the time has come to switch into assets which will hold or accumulate purchasing power with greater reliability. Dollars have become repellent. They are no longer the natural way of storing value, and this has broken one of the key conditions which is required to keep a linear relationship between money supply and inflation.
Negligible saving, increasing indebtedness, low interest rates, exploding asset prices, tumbling currencies and weak economies all provide warnings of what may be about to happen. It will be awful; and so permanent that almost no-one dares face such a grisly reality.
The chasm and the precipice on Mt Utopia
Alan Greenspan is tasked with guiding a weak climber - the ever-expanding currency system - to the peak of Mt Economic Utopia. To the left is the chasm of hyperinflation and to the right the precipice of deflation, and the path narrows as it rises up to the distant summit.
On the lower sections of the mountain path it is wide enough to let our guides turn us round. But the closer we get to the summit the more everyone believes it is achievable. Mountaineers suffer the same problem. They call it "Summit fever" and it claims far more lives than bad luck ever did, by corrupting the powers of good judgement.
It takes a lot to turn one person away from a summit. Turning round a happy crowd is quite impossible. They would rather believe the optimism of the guides who talk of spectacular rates of 'sustainable growth'. They prefer government statisticians who add mandated public sector expenditure into economic growth figures, and they listen to commentators who refer to 'Goldilocks economies' and 'productivity miracles'. So they buy more sports utility vehicles on borrowed money and re-finance their houses.
Yet domestic economic activity has no real growth, and high imports cause huge trade deficits. Savings rates diminish, financial instrument yields evaporate, governments borrow and spend and call it 'investment', corporations report profits which have nothing to do with earned cash, financial trickery permeates all levels of society and credit is offered to an ever increasing set of less well qualified borrowers, whether sovereign states, companies or individuals.
The majority cannot see these signs for what they are. Only a few miserable realists look around and, seeing the dangers on both sides, turn back on their own and face the cheerful smiles of those who continue on up.
It's a long lonely walk down and there'll be no-one waiting at the bottom to cheer your safe return.
Articles in the series include :-