Hyperinflation Article II - How Does Fiat Currency End — Part II: Hyperinflation

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July 15, 2010


How Does Fiat Currency End — Part II: Hyperinflation 

Wealthcycles.com

In a now infamous 2002 speech, U.S. Federal Reserve Chair Ben Bernanke, referring to a phrase originally coined by economist Milton Friedman, invoked the image of using a helicopter to drop money bombs on the populace as a way of combating deflation. The speech both earned Bernanke the nickname “Helicopter Ben” and provided a hint of the extreme measures to which the Fed would be willing to resort to ward off a severe deflation.

As I wrote last week in How Does Fiat Currency End—Fire or Ice? Part 1: Deflation, I believe the beginning of the end of the dollar will be a deflationary collapse of our economy. Despite the popular misperception that we are in an inflationary period, in fact the total currency supply (base money in circulation plus money created via consumer credit, or M3) peaked in 2009, then began to contract. The only way to sustain the currency bubble is to expand debt—and borrowing has slowed. In reaction, the Fed pulled out all stops in flooding the economy with new currency. That is exactly the type of desperate, knee-jerk response, in an attempt to stave off deflation, that I predict will ignite the flames of hyperinflation. And it may very possibly have already started.

But say black Fed helicopters were to drop fresh bundles of warm dollars into your lap, as Bernanke hinted in his 2002 speech, where would you spend them first? Most people would head straight for the grocery store or maybe Wal-Mart, to stock up on food and household items. Many would invest their cash in stocks and precious metals. The increased demand and the influx of newly minted currency would push prices up, and each unit of currency would buy less than it could buy before this theoretical helicopter drop, resulting in inflation. As people perceived the value of their currency dissipating they would rush to convert their currency into tangible goods, hoarding anything of value they could lay hands on, before the value of their paper money declined even more. But even as runaway inflation swept through society, deflation would continue to hold sway in those areas that rely on lending, such as residential and commercial real estate and auto sales.

I call this condition “indeflation,” when both deflation and inflation exist simultaneously. And it’s a condition I believe could easily occur, if the world’s governments and central banks, desperate to pull out of a deflationary spiral, react, as Bernanke’s 2002 speech infers, by flooding their economies with massive amounts of new currency.

What is Hyperinflation?

The problem with fighting deflation by printing money is that, while a flood of currency might be able to push prices up (and stem deflation) temporarily, it would have the vicious side-effect of inflation, or worse—hyperinflation.

You may have seen photographs from Germany during the 1920s or from Zimbabwe in 2008, of people pushing wheelbarrows full of cash to the grocery store to buy a few basic food items. Several trillion dollars, notes, or whatever your country’s fiat currency is called, might buy a loaf of bread, a jar of mayonnaise, or a single egg. These are the images of hyperinflation.

"It was horrible. Horrible! Like lightning it struck. No one was prepared. You cannot imagine the rapidity with which the whole thing happened. The shelves in the grocery stores were empty. You could buy nothing with your paper money."

Friedrich Kessler, law professor at Harvard and University of California Berkeley; survivor of the Weimar Republic hyperinflation

In a worst-case scenario, the currency of a nation in hyperinflation becomes worth more as fuel to keep a fire burning than as money for purchasing goods. In these dire examples, the currency that people spent years toiling for and saving for the future is rendered utterly worthless.

Webster's dictionary defines inflation as: “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” The government would have you believe that inflation is simply rising prices, but economists like Milton Friedman view inflation/deflation as the management of money supply through the easing or tightening of paper cash and credit—more money equals more inflation.

"Inflation is always and everywhere a monetary phenomenon."

Milton Friedman

Similarly, the Austrian economists believe that inflation is defined as an increase in the money supply and that rising prices are merely a consequence of this increase.

The term inflation originally referred to the debasement of real money. Historically, when and where gold was used as currency, the government could collect gold coins, melt them down, mix the gold with base metals such copper or lead, and reissue at the same face value—voilà! The supply of currency grew. As I explained in my book, Guide to Investing in Gold & Silver, the empire of Athens was among the first to use this trickery in order to continue funding a war that lasted 22 years and drained a spectacular amount of resources.

Indeed, many observers believe that the government has deliberately changed the definition and obscured the true meaning of the term inflation in an attempt to hide its underlying cause—the debasement of the currency. Once the public starts connecting the rise in prices with the printing of money (which central banks and government control) they can start to lay blame where blame is due. This is precisely why inflation is referred to as the “hidden tax” —most people fail to notice that every new dollar printed reduces the value of every dollar already in existence, including the hard-earned dollars they have already worked for and saved.

Despite central bank propaganda, inflation is volatile and can never really be tamed. With a fiat currency, inflation can quickly spiral out of control, and the peril of hyperinflation always looms.

Hyperinflation is brought on by both a rapid increase in the supply of money and in the velocity of money, the average frequency with which a unit of currency is spent, or changes hands. The massive increase in the money supply is not supported by growth in the nation's output of goods and services, and the people lose confidence in the money faster than more of it can be printed. When this happens, cash becomes a hot potato, and people get rid of it as quickly as they can.

Hyperinflation in Your Country: Is It Possible?

Given the interventionist and deflation-phobic tendencies of our government leaders and the Federal Reserve, is hyperinflation possible in a superpower economy such as the United States or in other developed nations? And if so, how would it happen?

I see two potential paths governments and nations may take, leading to two very different economic futures:

1) Restrain spending, root out corruption, revamp the financial system and allow free markets to determine sound money, interest rates, and true supply and demand.

2) Attempt to patch the massive holes in the current system, leading inevitably to increased debt, inflation, economic hardship, civil unrest, political upheaval and even war.

Some modern societies have managed to recover from hyperinflationary periods, including post-World War I Germany and Latin American nations such as Bolivia and Brazil in the 1980s, which bounced back to become promising emerging markets in today’s global economy. In all cases, those countries emerged from hyperinflation only after enacting strict fiscal controls, taking financial regulatory powers away from political leaders and allowing free market mechanisms to restore equilibrium to their economies. It’s hard to imagine such discipline being instilled today in the United States and other developed nations, where political leaders are unwilling or unable to inflict short-term pain on the voting public in the interest of long-term economic health.

Staying the Course 
Based on Fed statements and Bernanke's history, it seems evident that the Fed's biggest fear is deflation, not inflation. Thus the most likely scenario for our economic future is that the government and the Fed will use every tool in their arsenals to stave off a deflationary depression. These tools include a ramped-up schedule of “quantitative easing” (otherwise known as money-printing), stimulus programs, tax cuts, rebates and a continuance of near-zero interest rates. We also should expect that the government will continue meddling in the markets with new rules, regulations, committees and czars of one kind or another, all aimed at “managing” the economy and forcing lending, spending and any other business activity perceived to help fight deflation. (Sound familiar? Maybe a bit like the measures employed in the just-passed Dodd-Frank financial reform bill?)

In response to the crash of 2008, our leaders rewarded irresponsible firms with bailouts when their risky bets soured, and continue today to avoid holding the corporate institutions that led to our economic meltdown accountable. Hiding toxic assets or passing them on to future generations leaves a massive ticking time bomb that will eventually explode on an unsuspecting populace. Never in history have artificial controls or stimuli imposed by government or the financial establishment succeeded in correcting an economy. Any successes governments and central banks have had in controlling natural economic cycles have been short-term, only serving to prolong and exacerbate the inevitable and necessary free-market correction. Had the collapse of 2008 been allowed to play out free of government intervention, the short-term result would certainly have been instability and economic chaos.

But I believe, and many financial experts agree, that the hardship would have been shorter-lived and less severe than the future hardships set in motion by government intervention. Fighting deflation by fueling irresponsible levels of spending and debt is comparable to providing a drug addict a short-term fix, alleviating his suffering but ultimately leading to an overdose. The longer America's leaders try to window-dress and pave over the problems of unbridled debt and deficit spending, the longer, more painful and more severe the inevitable correction will be.

Even if the Fed were to completely shut down the printing presses once inflation becomes evident, it might be too late. The excess money and credit supplies will already have been created, and the Fed will find itself helpless to reverse course in time to avert the coming disaster. Once the vicious cycle of hyperinflation has been set in motion, extreme policy and regulatory measures will be required. But simply raising interest rates just won’t do it, as this will only make it more difficult for businesses and individuals to borrow.

To put our current economic situation into perspective, the banks today are sitting on currency reserves created by the Federal Reserve over the past two years. If and when the banks begin lending out those reserves, they will have the power to create up to$12 trillion in new money. To understand the scope of this massive potential currency expansion, consider that right now the monetary aggregate M1—which includes physical currency, traveler’s checks, checking accounts, and other very liquid assets—is a mere $1.7 trillion.

What does all this mean? Simplified, it means that if Bernanke sits back and does absolutely no more harm, he has already injected enough reserves into the financial system to double the money supply. Even if Bernanke musters up the courage to do the politically difficult thing and raise interest rates, thereby sucking out roughly half of the excess reserves, there would still be enough slack in the system to increase exponentially the existing money supply!

In other words, I believe we are past the point of no return. All we can do now is radio in the conditions and brace for the worst.

But knowledge is power. This gathering storm of economic turmoil contains opportunity. Any time one asset cycle ends, as the currency and debt cycles are about to do, and another begins, as the commodities and precious metals cycles are about to do, an enormous transfer of wealth occurs. The transfer of wealth that will inevitably follow these deflationary and hyperinflationary events presents us with the greatest opportunity of a lifetime.

Forecast: Partly Cloudy Today, Hyperinflation 2012-2015

As we know, the Fed’s overzealous efforts to combat deflation will eventually cause the pendulum to swing back the other way, sparking the flames of inflation and potentially hyperinflation.

One hyperinflation trigger is the Fed’s direct purchase of Treasury bonds. Essentially, Treasury bonds are dollar futures. You use some dollars today to purchase some greater amount of dollars in the future.

The day will come when no one will want to buy this Treasury debt, forcing the Fed to become the buyer of last resort. This will have a collateral effect, as other bond markets that are unsupported by the Fed will begin to collapse, making it necessary for Fed monetization of all types of bonds: munis, corporates and everything else. If you think this is unrealistic, think again—Ben Bernanke mentioned it as a Fed Policy tool in a 2002 speech. Considering the size of the bond market, such a move to avert a breakdown could easily cause panic selling of dollars and a dangerous drop in the value of the dollar.

Here's another problem: the U.S. trade balance.

A trade balance is computed by taking all the goods you export and subtracting all the goods you import. If you import more than you export, the number is negative. Use yourself as an example: if the food, clothing, cars, and sundries that you consume cost more than you earn, you have a deficit. You can finance that deficit by borrowing—and that is exactly what the United States does

This chart shows the U.S. trade balance firmly in negative territory — to the tune of $55 billion dollars. In addition to our national deficit (our annual credit card statement), and the national debt (our total credit card bill), we must borrow to finance our imports.

The international monetary agreement in effect from 1944 to 1974, the Bretton Woods System, had the effect of establishing the U.S. dollar as both the world’s reserve currency, meaning central banks hold their reserves in dollars, and as an international pricing currency for commodities such as gold or oil.

Eventually, though, the piper must be paid. As U.S. debt grows and the inflation of the dollar continues unabated, foreign lenders eventually will tire of trading their goods in exchange for dollars or debt that loses value immediately. It is estimated that 50% to 70% of U.S. dollars are currently being held outside the borders of the United States. If the dollar were to lose its status as a world reserve currency, and foreigners no longer needed to hold or trade in dollars, all those dollars could come rushing home, resulting in massive inflation in the United States. The loss of the U.S. dollar’s status as the world reserve currency would likely result in a selling frenzy, with the nations of the world rushing to make sure they were not the last ones left holding the bag and creating the likelihood of runaway hyperinflation in the United States.

How Inflation/Hyperinflation Affects People

As noted earlier, inflation is often referred to as the “hidden tax” because citizens remain largely unaware of its impact. Outright tax increases are politically thorny. So, rather than raise taxes, governments simply run deficits and print money or issue debt to cover the shortfall. This process levies a hidden tax on the citizens by debasing the value of the currency they hold. The inflationary impact occurs slowly at first, with mild, steady increases in prices of everyday items.

But the hidden tax of inflation does more than just steal the purchasing power of the people; it robs them of the honestly earned fruits of their labor, thus stealing their hours, days and lives. It also requires people to spend more time transferring their currency into assets that hold value. As inflation accelerates into hyperinflation, people may be paid multiple times a day so that they can go shopping before their currency becomes worthless.

Inflation also transfers society's wealth away from the middle class and concentrates wealth among the rich. Those living on fixed incomes from investments or pensions are particularly hard hit, as their monthly payments continually buy less and less.

As inflation accelerates to hyperinflation, the gap between society’s “haves” and the “have-nots” widens, leading to an increase in theft and violent crimes. With no confidence in the future, people focus on short-term needs and resort to hoarding. After all, how do you map out a road to long-term recovery when a loaf of bread costs five times what it did the month before, or the week before.

Hyperinflation: A Golden Opportunity

While the impact of hyperinflation will be shocking and catastrophic to our modern way of life, it also will contain the seed of great good fortune for those with the foresight to prepare wisely. One inevitable effect of hyperinflation will be a massive transfer of wealth from one sector of the economy to another. As prices of everything from food and clothing to real estate and commodities skyrocket, the value of currency plummets.

During hyperinflation, as people realize their currency is worth less every moment they hold it, they rush to purchase anything that can be used to sustain life or store value. As the DOW is measured in hundreds of thousands, even trillions, of points, precious metals outperform stocks. Gold and silver prices will be double or more the price of the DOW.

In today’s interconnected global economy, the transfer of wealth resulting from hyperinflation will be greater than any time in history. As the public loses confidence in fiat currencies, it will rush to convert its wealth into real money. At that point the currency cycle will have played out, and the commodities cycle will be gaining force. Those holding the only currency of true value during hyperinflation, gold and silver, will not only have the ability to survive and protect their families, they will be positioned to profit from the greatest opportunity of our lifetimes.