Rob Parenteau explains why the the hyperinflationist deficit hawks need to take a deep breath.
After a two day blogging slugfest on fiscal deficits, I find that the question of hyperinflation now demands an answer. And here it is: fiscal deficit spending may be a necessary condition of hyperinflation, but it is hardly a sufficient condition.
Think this is yet another rant against the "deficit errorists?" Think again. Paul Krugman treated this question in his March 18th New York Times column:
Hyperinflation is actually a quite well understood phenomenon, and its causes aren't especially controversial among economists. It's basically about revenue: when governments can't either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage - revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.
Krugman locates the source of hyperinflation in what is termed the "monetization" of fiscal deficit spending. He then attributes its perpetuation to shifts in the liquidity preferences of people -- that is, the share of their portfolio that households and firms wish to hold in cash or cash like investment instruments (think Treasury bills, or money market mutual funds, for example). Krugman's logic means that even the liberal wing, or the saltwater contingent, of the economics world has a touch of deficit errorism. We would invite Paul to take a closer look at the UBS research on public debt to GDP ratios and inflation first released last summer, reprinted in a FT Alphaville note, and discussed on Naked Capitalism. The story of inflation and fiscal deficits is more ambiguous, or at least more complex than the deficit errorists would have you believe.
Coincidentally, an investment manager friend forwarded me a letter that Ebullio Capital Management* allegedly sent to its clients after February's investment results, which took them down nearly 96% for the year - virtually wiping out their stellar gains of the prior two years. The letter reveals that Ebullio was so ebullient about the possibility (inevitability?) of hyperinflation emerging from recent policy excesses that they bet the ranch on hyperinflation plays in the commodity corner of the investing world (metals), and lost big time. While we still have questions as to whether this is a spoof or not, there are undoubtedly people sitting around in gold wondering whether the old yellow dog is going to get up and bark again anytime soon. Although hyperinflation hyperventilation has been catching on in recent months, especially amongst the deficit errorists, gold has been dead money since late November 2009.
What gives? As a piece I wrote in the July issue of The Richebacher Letter explains, hyperinflation requires extreme conditions not just on the demand side, but on the supply side as well. A month after the Richebacher piece, Bill Mitchell published a similar conclusion. To summarize our findings: on the demand side, in order for household spending power to keep up with rising prices, household nominal incomes or credit access must be ratcheted up in synch with price hikes. Otherwise, the price hikes will not stick. Households will have to pull back less-essential spending areas to afford the same quantity of goods in essential items. So your gas, home heating oil, health care, or food bill goes up, and you cut back on your restaurant and entertainment spending, unless your paycheck also increases, or you can tap more credit. That is why hyperinflation episodes need more than just deficit spending. It is true, as Marshall Auerback and I explained in a recent New Deal 2.0 post, that fiscal deficits increase the net cash flow for the household sector as a whole. But we also usually observe some sort of escalator clauses or cost of living adjustment mechanisms built into wage contracts that allow this ratcheting up of household income pari passu with the inflation hikes. Take that element away -- and it is a recurring theme in historical episodes of hyperinflation -- and households cannot keep up with hyperinflation. The higher prices cannot get validated by higher consumer spending. The hyperinflation flares out.
Beyond this demand side component, which is scarcely to be found in the US wage contracts these days (although we must mention it is built into some government benefit programs like social security), there is the supply side issue. Productive capacity must be closed or abandoned in order for the hyperinflation to really rip. There is a built-in dynamic that encourages this. As the hyperinflation gets recognized, entrepreneurs eventually figure out that they would be much better off speculating in commodities (like Ebullio), buying farmland, chasing gold and other precious metals, or more generally, repositioning their portfolios and reinvesting their profits in tangible assets with relatively fixed supplies. That is, goods that are fairly nonreproducible become stores of value, as it is their prices that tend to rise most swiftly, since higher prices cannot, by definition, elicit any new supplies. Hence, those of you who lived through the ‘70s (and still remember what you were doing) will recall high net worth households were busy hoarding ancient Chinese ceramics while the middle class was chasing residential real estate, and the stock market basically went sideways.
In the case of the Weimar Republic following WWI, and Zimbabwe most recently, remember that war (civil or international), has an impeccable way of destroying productive capacity in a nation, or rerouting it to the production of war material. In the Weimar episode, the final back-breaking run up in hyperinflation accompanied the occupation by the French of the Ruhr Valley, which held a fair concentration of German production facilities. In solidarity with the workers who struck those plants in response, the Weimar Republic continued to pay the workers through fiscal measures. Cut production, but continue income flows, and you have the recipe for the kind of unresolved distributional conflict that often lies at the heart of the inflation process. Mainstream economics and popular lore refuse to see this.
Suffice it to say that hyperinflation takes a very special set of conditions. It is not, contra Paul Krugman, all about fiscal deficits, nor is it only about fiscal deficits. That is why we do not see hyperinflation breaking out all over the place on any given day, despite the fact the governments have to first create the money that you and I use to pay taxes or buy Treasury bonds (because even though we "make" money, we cannot create it, without risking a spell in jail for counterfeiting). Know your history. Try not to pass out with the hyperventilating hyperinflationistas: they are a particularly virulent wing of the deficit errorists, and they may simply leave you in a state similar to the one alleged to have been experienced by Ebullio Capital Management's clients.
P.S. I have a piece called "On Fiscal Correctness and Animal Sacrifices" appearing on several blogs that formed the basis for the March 2010 Richebacher Letter. It is crucial that this piece get into the hands of Paul Krugman. If anyone knows how to get to him, I would be much obliged. His July 15th, 2009 NY Times diagram, which I call the Krugman Curve, has planted a seed that he would benefit greatly from watering. I believe it would help him escape the trap of continually returning to the manipulation of real interests rates (now requiring that he advocate central banks push a credible plan to deliver higher inflation in perpetuity, since policy rates are near the zero nominal bound in many places) as the holy grail for all countries operating below potential output. Time for him to exit from the IS/LM straight jacket, which even Sir John Hicks, one of its fathers, had his sincere doubts about, as well as the intertemporal utility maximization straight jacket of his more orthodox contemporaries. He knows how to do it...he just does not know it yet, which is why this paper needs to get in his hands, and soon, before the deficit errorists claim him as one of their own.
* You can go to Ebullio's website, but unfortunately, authorization is required to see their performance, their track record, and their client letters.
Rob Parenteau, CFA, is sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and research associate at the Levy Economics Institute.