Chapter 7 (Excerpt)
Currency Debasement Inflation
“But then the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy that will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them…. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German mark in 1923.” From The Theory of Money and Credit (1953), by Ludwig von Mises (1881–1973) (emphasis added by the author). Appendix 1 has more of this quote, and is recommended reading.
A proper understanding of this chapter is critical. The inflation argument rests on whether you believe a government can generate inflation through monetary debasement. I believe most people seriously underestimate the danger of this kind of inflation.
Negative real interest rates normally result in currency weakness. Why is this? It’s because investors are selling the currency to purchase what they perceive to be a better store of value. The following chart shows the 96 percent loss in purchasing power of the U.S. dollar since the Federal Reserve Bank was established in 1913.
The following chart is from the Federal Reserve Bank of St. Louis and shows a sharp rise in the monetary base beginning with all the government bailout activity in 2008–09.
It would be a mistake to believe that the United States is the only country expanding its money base. Look at this chart of the world’s twenty largest economies.
Inflation bulls will look at these money supply charts and say something like, “It’s just a matter of time until inflation really kicks in.” While I agree with that statement in the long run, we must not forget to look at the next factor: velocity.
The Velocity Factor
M1 is defined as all currency in circulation plus checking account deposits and checkable deposits in banks, credit unions, and other depository institutions. The M1 multiplier is the ratio of M1 to the adjusted monetary base. This ratio measures the velocity of money in circulation. Here is the graph of the M1 multiplier from the Federal Reserve Bank of St. Louis:
The adjusted monetary base chart shows that money is going into the banking system, but this chart shows that it is not being loaned out. This could happen for a couple of reasons. Banks may have tightened their lending standards and could be using the money to rebuild their capital base. Also, borrowers could be reluctant to acquire new debt in the midst of a recession. In any case, money velocity should increase before there is a rise in the inflation rate.
Can a Central Bank Create Inflation?
The crux of the entire inflation/deflation debate rests right here. Clearly, monetary expansion alone will not create inflation when there is a large amount of bad debt in the system and the banks are using bailout money to recapitalize (credit deflation). The question then asked is, “Can the government force banks to lend, or can the government bypass the banks altogether?” Let’s review what Ben Bernanke said in his famous 2002 “helicopter” speech:
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.” Ben Bernanke: “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” November 2002
So what is Mr. Bernanke saying? I believe he is highlighting three key things:
- Japan did not try hard enough to get out of their deflation.
- You can bypass the banks when you need to.
- Velocity—and inflation—will take place when people see that you intend to continually devalue the currency by creating more and more of it.
What Will Cause Money Velocity to Increase?
- Healthy economy—renewed bank lending with sound loans
- Bank lending forced by the government (e.g., socialism)
- Debt monetization—people fleeing the currency because they are seeking a store of value.
I am not aware of any instance where the following formula did not eventually work:
Debt monetization = Currency devaluation = Higher inflation
Of course, critics will argue that Japan followed this course of action and did not have an inflation problem. The Japanese economy has been caught in a Liquidity Trap for the past 20 years. A Liquidity Trap is defined in Keynesian economic terms as a situation in which neither lower interest rates nor increases in money supply are able to stimulate the economy. During this time, the Bank of Japan lowered interest rates to zero in addition to its quantitative easing policy. My response to the “Japan” argument is that inflation (and asset bubbles) did occur, just not so much within Japan. The yen carry trade (borrowing in yen and investing the proceeds in all sorts of things all over the world) resulted in inflated stock and bond markets globally as Japanese investors sought out investment alternatives outside of Japan.
Others may be inclined to point to the United States. In the early 1980s, when Fed Chairman Paul Volcker slew the inflation dragon, gold peaked at $850 per ounce in January 1980 and then fell like a rock. But we must ask this question: “How did he do that?” He did it by raising interest rates to 20 percent while inflation was running at 12 percent. This resulted in a positive real interest rate of 8 percent! At that point, it made sense to sell gold (and just about anything else) and put the proceeds in savings or government bonds.
I believe it is helpful to take a look at what happened to the U.S. dollar in the 1970s and early 1980s when real interest rates went from -4 percent to +8 percent:
When Richard Nixon completely removed the United States from the gold standard in 1971 and real interest rates were negative, the dollar declined 30 percent against the currency basket through the 1970s. However, when Paul Volcker started dramatically raising U.S. interest rates in late 1979, the dollar started shooting up and almost doubled in value against the basket by 1985. Of course, the dollar declined once again when the Fed cut rates in the 1984–87 time period.
History clearly shows that raising interest rates well above the inflation rate will reverse the inflationary trend and attract money back into the currency. However, does anyone have the political courage to raise interest rates significantly in this environment? I believe that it is doubtful because of the fragility of the economy and the financial system.
Be Aware of the Deflation Head-fake
A review of monetary history shows that there have been instances when a period of high inflation, or hyperinflation, was preceded by a period of deflation. One example that comes to mind is the Weimar Republic (Germany, pre-World War II).
Are we in such a period now? It is impossible to know for sure, but a loss of confidence in the currency would make such a scenario very likely.
A Matter of Confidence
It is important to realize that confidence in paper money can be here one minute and gone the next. Here is what happened to the U.S. Continental dollar in the 1700s. These dollars were issued to help fund the American Revolution.
Here is another example from Weimar Republic Germany that shows how quickly money can become worthless:
In conclusion, I make the following observations:
- Money velocity and inflation expectations can change very quickly, especially when there is a sudden loss of confidence in the currency.
- I believe Ben Bernanke when he says he can create inflation through currency debasement. What he does not mention, however, is that a loss of confidence in a currency is virtually impossible to control.
One closing note to this section: most people incorrectly believe that there was deflation throughout the Great Depression. While it is true that prices went down early in the Great Depression, they went up after gold was confiscated by Franklin Roosevelt in 1933. Here is the chart of inflation rates during the Great Depression. As you can see, deflation was prevalent early in the Great Depression, but inflation took hold in the second half of 1933 after gold was confiscated and the dollar was devalued.