Wednesday, August 25, 2010

Hyperinflation? Ain’t Happening

There’s a popular belief that’s been hanging around since late 2008 that the US and other countries that have engaged in quantitative easing a.k.a. money printing, are going to experience hyperinflation and currency collapses. If you’re not familiar with the term, it’s inflation on steroids, where currency losses its value faster than you can spend it, and where prices are higher in the afternoon than it is in the morning.

The most recent and historically extreme example of the hyperinflation phenomenon is of course Zimbabwe, which has come to symbolise economic and monetary mismanagement on an unbelievable scale. But hyperinflation is not just a disease of weak and developing nations. The other prominent example is the short-lived Weimar Republic, the government that replaced Imperial Germany in the aftermath of World War I. There have of course been lesser borderline cases in the past century, notably Argentina and Turkey, though inflation in those countries never reached the sublime heights it did in Zimbabwe and Germany.

The proximate cause of hyperinflation is of course indiscriminate and profligate use of the “printing press” where money is created (these days of course, electronically) above and beyond the ability of government, via its ability to tax, can actually credibly back. it.

The theoretical model goes back to Irving Fisher in the early part of the 20th century, through the quantity theory of money:

M x V = P x Q

…where M is the money supply, V is the velocity of money, P is the price level, and Q the output level. For a given level of velocity and if output is at its maximum potential, then an increase in the money supply feeds directly into an increase in the price level. In the vulgar, inflation is caused by “too much money chasing too few goods”. This is intuitively satisfying, as it’s also well known that the current monetary system is based on fractional reserve banking (read this post for a description), where money can be created out of thin air and is backed by nothing. Hence an excess of money creation leads to inflation, and very excessive money creation leads to hyperinflation.

Now, I’ve never subscribed to the notion that the quantitative easing (hereinafter known as QE) done by the Federal Reserve, the European Central Bank, Bank of Japan and Bank of England in the past couple of years, which is functionally the same as money printing, would lead to hyperinflation as such. Certainly its never been the case in Japan, which has been indulging in QE for parts of the past two decades, and suffering deflation the whole while.

But I did think that at some stage, with economic recovery, even the limited amount of QE being done would eventually lead to higher inflation somewhere down the road. This article on Business Week pretty much sums up the worst case scenario – creation of excess high-powered money would lead to much faster credit creation and asset price bubbles, which in turn lead to too much money chasing too few goods.

What has brought this to mind is the engaging online debate regarding Kelantan’s issuing of the gold dinar and silver dirham, as well as my reflecting on the bubbling gold market. If higher inflation were to hit in the not so distant future, together with the currency debasement implied by quantitative easing, then gold (and other hard commodity assets) would indeed be a reasonable investment.

My own thinking over the past year was that credit creation after a balance sheet recession as the West has just undergone is typically weak, which gives time for all these central banks to shrink their own balance sheets before those excess reserves actually leaked through into the broader economy. The financial sectors in the US and Europe have been through a traumatic time, and have to repair their own balance sheets before they would be willing to lend again. Then there’s damaged household balance sheets, where so many people are holding negative equity on their own homes that they would not be willing to borrow for years to come. But even to me, these arguments aren’t quite satisfying in the face of central bank balance sheets that have more than doubled in size, and monetary bases  exponentially higher than before the Great Recession started.

That is until yesterday, when I had an epiphany. That thudding sound you’re hearing is me kicking myself for not figuring this out earlier, since the solution has been staring me in the face all this while.

The fundamental problem with the narrative I’ve given above about excess reserve creation leading to excess credit creation leading to inflation, via the quantity theory of money, is that it’s an essentially 19th century narrative geared towards a fiat money system backed by gold or silver. It doesn’t apply to an unbacked fiat money system, nor – and this is the important point – does it even come close to describing how the modern monetary system actually works. And I’m.kicking myself because I saw (and wrote about) this in the Malaysian financial system months ago, but didn’t take the conceptual leap of applying this insight more generally to the global financial system.

All that stuff about excess reserves is frankly a complete crock. The modern limits on bank lending isn’t defined by the ability to apply leverage on the reserve ratio, where the amount of reserves available actually matters. It’s the capital adequacy ratios that actually matter now, and those are much, much higher than existing reserve ratios. I’ve seen enough corporate loan approval documentation that I should have realised this earlier –credit officers in my experience never bother about the reserve ratios, but the impact of a loan on CAR is always stated.

Banks and other financial institutions are going to come up against prudential limits on their capital bases well before they even come close to utilising the potential lending they can do via fractional reserve lending. And capital bases in the western world aren’t terribly healthy, as demonstrated by the stress tests conducted in Europe a couple of months back. Credit growth, and for that matter accumulation of other financial assets, must be preceded by repair and growth in capital bases, which is going to be a very slow process.

So my initial intuition that a dysfunctional western world financial system will limit credit creation and thus inflationary demand pressure was accurate, it’s just that I now have a much more empirically satisfactory basis for backing that intuition up.

But QE is of course more than just about bank lending. If monetary policy traction is limited by a broken transmission mechanism, as is the case with the global financial system today, governments can bypass it and feed money directly into the economy via fiscal policy. Central bank purchases of government debt is functionally equivalent to money printing as well. And this direct route is precisely how Zimbabwe and the Weimar Republic managed to trigger hyperinflation.

The US fiscal stimulus of 2009 is by far the largest in recorded history both in size and in scope – grounds for inflation you would think, even with the drop in output caused by the recession. But this won’t have any inflationary effect either, because – just as in Malaysiathere wasn’t any fiscal stimulus.

I actually featured the research work that pointed this out months ago. Essentially what happened was that the additional spending by the central federal government was almost exactly matched by the drop in state government spending. The state governments are more limited in the ways they can raise revenue or borrow – many have legal balanced budget requirements – and even now are having trouble meeting basic spending needs. I would not be surprised if US federal government spending is at best filling this gap, and not even coming close to sustaining aggregate demand. Europe on the other hand is bizarrely embarking on fiscal austerity in the midst of a weak recovery – no added inflationary pressure there either.

In short, the hyperinflation scenario, while superficially plausible, would only work if we actually lived in an Econ 101 world.

We don’t, the US dollar isn’t going to collapse, and civilisation isn’t going to end tomorrow.

7 comments:

  1. bro hishamh

    I'm expecting a greater contraction of the Credit triangle going forward especially after the introduction of various legislation under the Dodd Frank.....

    But what would be interesting to watch is how the Fed eventually shrink its balance sheet and the impact to prices in general...unless they plan to do a massive one time write off to cushion the impact?

    From what i understand of most Central Bank operations they must keep a positive net balance against Government to avoid deposit financing activities....or printing money as you've highlighted in your post...but the case u've mentioned are CB's with very little credibility....

    take care n selamat berbuka puasa to u n fam

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  2. bro satD,

    Hope your fasting is going ok.

    I agree that there will be continued deleveraging, although I'm not sure that Dodd-Frank went far enough to contain future excesses (what happened to the Volcker rule?).

    But I don't think that there will be any shrinkage in the balance sheets of the major central banks - at worst you'll see changes in the asset composition as holdings of sovereign and agency debt matures.

    Here's the (new) scenario I'm thinking about. The massive expansion in CB balance sheets was essentially to accommodate and socialise the existing over-leveraging in the shadow banking system, in other words to bring on board public balance sheets what was previously hidden off private balance sheets.

    That means that the "hyperinflation" has actually been and gone (it occured in asset prices, not consumer prices), and current expanded CB balance sheets are just adjusting to the new "normal" ex post facto.

    Which in turn implies that the current and ongoing deleveraging is actually making monetary policy in the west progresively tighter (money is beng destroyed, and the money multiplier is dropping), despite zero interest rates and quantitative easing.

    How's that for an off-the-wall viewpoint?

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  3. This comment has been removed by the author.

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  4. i just lost my comment..got bug here?

    anyway a rewrite....lain kali copy paste is required...

    Volcker is in

    refer here
    http://www.davispolk.com/files/Publication/bc70cd4c-c6bd-472d-ad37-0a63481fe36a/Presentation/PublicationAttachment/6a2f81d8-d5c5-4d5d-9b97-fef48b6821e6/070910_Implementation_Slides.pdf

    U'll notice that Other Prudential controls can be enforced on Systemic Financial Institutions once the committee designate them (which includes non banks as well)

    On the Public Private Balance scenario...yes agree.

    to top it all on the private side the Deleveraging is happening on both sides..n will be even more so once Dodd comes into the picture with the subsequent regulatory actions..

    Insititutions will want to deleverage and hold more precautionary balances. As for the demand-side, potential borrowers are deleveraging, too.

    Both are attempting to bring their debt levels down relative to their income flows. In consequence, both the demand for and supply of credit has shrunk and will continue over the medium term.

    Will this put more pressure on the Public Side? Unless CB can find innovative ways to stimulate private demand for credit....monetary policy will have very little effect.....

    True that "near term contraction" on CB's balance sheet may not be something on the cards but how long can the situation be?

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  5. Sorry you got caught in Blogger's new spam filter - I think it's because of the long link.

    Anyway, I don't think there will be a scenario where the CBs balance sheets will shrink much, if at all. That's the problem with financial crises - the liquidity injection is permanent, even if non-inflationary.

    Looking back at BNM's balance sheet post-1998, it didn't shrink much either.

    There's a growing feeling among the more prominent economics bloggers that current Fed policy is actually deflationary i.e. too tight. Bernanke's speech yesterday certainly indicates he's leaning towards further QE. Deleveraging is exacerbating the situation, and until that stops, we're not going to see credit expansion. But under those circumstances, further loosening of monetary policy will still not be inflationary, and still won't even if the credit situation normalises.

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  6. The question of QE is different for Japan vs US!

    The key question is where the source of the money comes from.

    In US, money comes from other countries because of US dollar currency status as the world trade currency. In other words, others countries are feeding the consumption for US.

    Japan, take money from own people savings. They're feeding with their own money. PLUS, the money is used for capital expenditure which will enhance productivity. This is a vast difference.

    US borrow money to CONSUME!!!

    The question for high inflation in US is not whether it will happen or not, but when.

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  7. @Anon

    I think you're confusing QE with fiscal policy. QE is a monetary policy tool, and has little or nothing to do with government borrowing per se.

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