Wednesday, September 18, 2013 9:54:15 AM
How Fiat Dies
Hyperinflation is that transition period when a paper money is clearly failing as a store of value but has not yet died as a medium of exchange. This blog is to look at this and any other interesting economic issues. Vincent Cate
Sunday, September 15, 2013
Hyperinflation Explained in Many Different Ways
Hyperinflation is part of the experimental data that any good economic theory should be able to explain. There are many different economic schools of thought and they often have very different views of hyperinflation. I am trying to collect as many different explanations here as I can. I think it is fun to be able to understand this problem from many different angles. If you know of any others please comment.
Equation of Exchange
There can be a feedback loop where the more the central bank makes money and buys bonds the less people want to hold bonds, but the less people hold bonds the more the central bank has to monetize so the government has cash to operate. This can result in a flood of new money and an increase in the velocity of money. Governments almost always try to fight inflation with price controls. The resulting shortages reduce the real GNP. Using the equation of exchange view of hyperinflation we can see that if the money supply is going up fast, the velocity of money is going up fast, and GNP is going down that prices will go up very fast. Hyperinflation can be simulated using this view.
Corrected Modern Monetary Theory
A simple model makes it easy to understand hyperinflation. In this model all government spending uses newly made money and we imagine money collected from taxes and bond sales is just destroyed. In this model bonds are paid off with newly made money. If much of the government debt is short term, and people stop rolling over bonds, then the government would end up paying off lots of bonds with lots of new money. If there is a full bond panic, then this could result in hyperinflation.
Unsustainable Interest Expense
If the deficit is large then the debt and the interest on the debt can both be growing faster than the tax base. In this case then, at some point, the interest on the debt adds so much to the debt that it is clear there is no hope of really paying this off. Often about when this is becoming clear the interest rates go up and the interest expense shoots up so that it is obvious to all this can not go on. The alternative is for the central bank to peg interest rates by buying bonds very fast. Either way, it gets to where the government can really do is print money to pay off the debt. This then makes lots of new money and the value of each unit goes way down.
Krugman's View
Inflation is a tax on those who hold money. The higher taxes are the more people change their behavior to avoid the taxes. As the inflation tax gets higher and higher people change what they do so that the real value of the money they hold goes down. This involves spending money faster and keeping lower real balances. This can make the total real value of the currency outstanding go down even as the nominal value is shooting up. But the lower the real value of currency out there the faster the government needs to print money to collect enough inflation tax to keep in operation. This can spiral out of control, often to where people avoid that currency altogether. Search for Krugman here for more.
Backing View or Real Bills Doctrine
In the Real Bills Doctrine a bank can issue as many notes as it wants without causing inflation as long as it gets assets of real value that could be sold to withdraw the notes. If it is getting bonds they should be for less than 60 days and come with collateral. In hyperinflation the central bank buys government bonds. The problem here is that the only collateral is a real tax base. So the more bonds they buy the less real collateral they have per bond. Also, they typically buy long term bonds which go down in value as interest rates go up. So the current value of the assets backing the notes per note issued goes down. The value of notes is determined by the value of the assets per note, so the value of the notes goes down if the value of the assets goes down. This can spiral out of control. As the notes go down, the value of the bonds goes down, but as the value of the bonds goes down, the value of the notes goes down. As you get hyperinflation the government gets weaker and the amount of real taxes collected goes down. This further reduces the value of the backing/bonds at the central bank. This feedback loop can go on and destroy the currency.
Supply and Demand
If a currency is losing value fast the demand for that currency goes down. This makes the value of the currency go down even more. If the government needs to print money to cover a deficit of a certain real total value, to cover real expenses in the real world (employees, retired people, unemployed), then as the value of the currency goes down it is forced to increase the supply faster and faster. This can spiral out of control with supply going up fast while demand goes down fast and the currency gets destroyed.
Rational Expectations
Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being. History shows that when the government starts using new money to fund a big deficit that the currency will go down. Once economic actors expect the currency to go down, they work to avoid that currency. The faster it is going down the harder they work to avoid it. The more people try to avoid the currency the more it goes down. You can get a feedback loop or panic. Eventually everyone is out of that currency.
Half Dead Money
Good money is both a store of value and a medium of exchange. During hyperinflation the currency is no longer a good store of value. It can be viewed as half dead money. Such money often keeps losing value till it eventually becomes completely dead.
Loss of Confidence
For some reason the public becomes less confidence in the currency. This may be from too much new money, from central bank monetizing government debt, from war, from corrupt government, or whatever. As the public loses confidence they don't want to hold the currency as long and the velocity of money goes up. However, as the velocity goes up the prices go up, which makes confidence even lower. This can spiral out of control.
Inflate Away the Debt
The idea here is that those in charge have decided to inflate away the national debt by printing money and this causes hyperinflation. If politicians have ever made such a decision I can not find them admitting it publicly. To me hyperinflation happens when there is no good way out of a bad situation. I doubt there was ever a "vote for hyperinflation". Perhaps they voted to monetize the debt but did not understand it would cause hyperinflation. I can not even find that though.
When Politicians Get Control of Printing Press
Politicians can spend unlimited amounts once they are able to get as much money as they want from the printing presses. Usually this is done by getting control of the central bank and making them buy as many government bonds as needed. Once this is how things work, all restraints on the amount of money are gone. The more they print, the higher the prices. The higher the prices, the more they print. They print and spend into oblivion.
Khan Academy
The Khan Academy video explains hyperinflation as two feedback loops. First, the more the government prints, the higher the prices go, but the higher the prices go, the more the government needs to print to pay for whatever it needs to pay for. The other cycle is that the faster prices go up the more people hoard real goods. But the more people hoard real goods and less cash, the bigger the impact of constant real value of new money (and so bigger nominal value). Hoarding can be done by buying extra stuff ahead of when they normally would or waiting to sell things until prices have gone up. They keep less cash and more real goods. These two cycles can go on and on and prices keep going up.
Addiction to Monetary Heroin
The economy and government get addicted to cheap money. If at any point the cheap money is removed the economy and government will nearly fall apart. But over time a larger and larger dosage is needed. Eventually the patient dies.
Taxes for Bond Holders
Bond holders that are paid with money collected from taxes can expect to get the value of their initial investment back plus interest. However, when governments start printing money to pay bond holders the value of the money will be going down and holding bonds for years is a bad deal. Bond holders know this and can head for the exits when governments start doing this. The faster bond holders exit the faster the government will print. So this can spiral out of control in a bond panic.
Lenin's View
There is no subtler, no surer way to overturn the existing basis of society to than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner, which not one man in a million is able to diagnose. -As reported by Keynes
Modern Monetary Theory and Monetary Realism
In these theories hyperinflation is viewed as a political issue and not a monetary issue. They look for some trigger to blame the whole hyperinflation on. This may be a supply shock, a loss of productive capacity, corrupt or unstable government, or external factors like war. This will be some reason the government was deficit spending. While normally very into detail, even at the level of each debit and credit for monetary operations, when it comes to hyperinflation, they skip over all the detail of the mechanics of hyperinflation.
They always name the initial trigger after the hyperinflation has started and they know to go looking for one. They do not seem to have any ability to predict hyperinflation ahead of time and never discuss the mechanics of how it works or goes on for so long. If Japan gets hyperinflation, then they might trace things back to the tsunami and say that was the core cause; however, they could not tell you now if the tsunami will lead to hyperinflation in the future.
These two theories do not seem to help at all in warning when hyperinflation might start nor in really understanding how it works. All the other theories above can give you some insight to how hyperinflation happens. These are more like, "sometimes war causes hyperinflation", without talking about how or any of the steps that go on so you might be able to predict which wars would cause hyperinflation.
Since these two schools of economic thought seem unwilling to explain the mechanics of hyperinflation in their own theories, I will do it for them. In these theories government bonds are part of the money supply. Each time the government makes a new bond out of thin air and sells it, they add to the money supply. In these theories, if the government budget and deficit are out of control, then the money supply is also out of control. As prices go up the government needs to make more bonds to be able to handle the new higher prices. However, the more bonds they make the more prices go up. This spirals out of control, making hyperinflation.
Mix and Match
Note that you can mix and match parts from different explanations above to make your own explanation.
They are not contradictory but just different ways of talking about what is going on. It reminds me of the blind men describing an elephant. Maybe with all of these together we are getting close to understanding.
Predicting the Timing
I think that you really can understand the mechanics of hyperinflation if you can understand all these different explanations. However, predicting when hyperinflation starts is a much harder problem, one that I do not claim to have solved, yet.
Others Views of Hyperinflation
As I think of other ways to explain hyperinflation I will add them. If you know of any more please comment.
Posted by Vincent Cate at 5:19 AM
http://howfiatdies.blogspot.com/2013/09/hyperinflation-explained-in-many.html
Hyperinflation is that transition period when a paper money is clearly failing as a store of value but has not yet died as a medium of exchange. This blog is to look at this and any other interesting economic issues. Vincent Cate
Sunday, September 15, 2013
Hyperinflation Explained in Many Different Ways
Hyperinflation is part of the experimental data that any good economic theory should be able to explain. There are many different economic schools of thought and they often have very different views of hyperinflation. I am trying to collect as many different explanations here as I can. I think it is fun to be able to understand this problem from many different angles. If you know of any others please comment.
Equation of Exchange
There can be a feedback loop where the more the central bank makes money and buys bonds the less people want to hold bonds, but the less people hold bonds the more the central bank has to monetize so the government has cash to operate. This can result in a flood of new money and an increase in the velocity of money. Governments almost always try to fight inflation with price controls. The resulting shortages reduce the real GNP. Using the equation of exchange view of hyperinflation we can see that if the money supply is going up fast, the velocity of money is going up fast, and GNP is going down that prices will go up very fast. Hyperinflation can be simulated using this view.
Corrected Modern Monetary Theory
A simple model makes it easy to understand hyperinflation. In this model all government spending uses newly made money and we imagine money collected from taxes and bond sales is just destroyed. In this model bonds are paid off with newly made money. If much of the government debt is short term, and people stop rolling over bonds, then the government would end up paying off lots of bonds with lots of new money. If there is a full bond panic, then this could result in hyperinflation.
Unsustainable Interest Expense
If the deficit is large then the debt and the interest on the debt can both be growing faster than the tax base. In this case then, at some point, the interest on the debt adds so much to the debt that it is clear there is no hope of really paying this off. Often about when this is becoming clear the interest rates go up and the interest expense shoots up so that it is obvious to all this can not go on. The alternative is for the central bank to peg interest rates by buying bonds very fast. Either way, it gets to where the government can really do is print money to pay off the debt. This then makes lots of new money and the value of each unit goes way down.
Krugman's View
Inflation is a tax on those who hold money. The higher taxes are the more people change their behavior to avoid the taxes. As the inflation tax gets higher and higher people change what they do so that the real value of the money they hold goes down. This involves spending money faster and keeping lower real balances. This can make the total real value of the currency outstanding go down even as the nominal value is shooting up. But the lower the real value of currency out there the faster the government needs to print money to collect enough inflation tax to keep in operation. This can spiral out of control, often to where people avoid that currency altogether. Search for Krugman here for more.
Backing View or Real Bills Doctrine
In the Real Bills Doctrine a bank can issue as many notes as it wants without causing inflation as long as it gets assets of real value that could be sold to withdraw the notes. If it is getting bonds they should be for less than 60 days and come with collateral. In hyperinflation the central bank buys government bonds. The problem here is that the only collateral is a real tax base. So the more bonds they buy the less real collateral they have per bond. Also, they typically buy long term bonds which go down in value as interest rates go up. So the current value of the assets backing the notes per note issued goes down. The value of notes is determined by the value of the assets per note, so the value of the notes goes down if the value of the assets goes down. This can spiral out of control. As the notes go down, the value of the bonds goes down, but as the value of the bonds goes down, the value of the notes goes down. As you get hyperinflation the government gets weaker and the amount of real taxes collected goes down. This further reduces the value of the backing/bonds at the central bank. This feedback loop can go on and destroy the currency.
Supply and Demand
If a currency is losing value fast the demand for that currency goes down. This makes the value of the currency go down even more. If the government needs to print money to cover a deficit of a certain real total value, to cover real expenses in the real world (employees, retired people, unemployed), then as the value of the currency goes down it is forced to increase the supply faster and faster. This can spiral out of control with supply going up fast while demand goes down fast and the currency gets destroyed.
Rational Expectations
Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being. History shows that when the government starts using new money to fund a big deficit that the currency will go down. Once economic actors expect the currency to go down, they work to avoid that currency. The faster it is going down the harder they work to avoid it. The more people try to avoid the currency the more it goes down. You can get a feedback loop or panic. Eventually everyone is out of that currency.
Half Dead Money
Good money is both a store of value and a medium of exchange. During hyperinflation the currency is no longer a good store of value. It can be viewed as half dead money. Such money often keeps losing value till it eventually becomes completely dead.
Loss of Confidence
For some reason the public becomes less confidence in the currency. This may be from too much new money, from central bank monetizing government debt, from war, from corrupt government, or whatever. As the public loses confidence they don't want to hold the currency as long and the velocity of money goes up. However, as the velocity goes up the prices go up, which makes confidence even lower. This can spiral out of control.
Inflate Away the Debt
The idea here is that those in charge have decided to inflate away the national debt by printing money and this causes hyperinflation. If politicians have ever made such a decision I can not find them admitting it publicly. To me hyperinflation happens when there is no good way out of a bad situation. I doubt there was ever a "vote for hyperinflation". Perhaps they voted to monetize the debt but did not understand it would cause hyperinflation. I can not even find that though.
When Politicians Get Control of Printing Press
Politicians can spend unlimited amounts once they are able to get as much money as they want from the printing presses. Usually this is done by getting control of the central bank and making them buy as many government bonds as needed. Once this is how things work, all restraints on the amount of money are gone. The more they print, the higher the prices. The higher the prices, the more they print. They print and spend into oblivion.
Khan Academy
The Khan Academy video explains hyperinflation as two feedback loops. First, the more the government prints, the higher the prices go, but the higher the prices go, the more the government needs to print to pay for whatever it needs to pay for. The other cycle is that the faster prices go up the more people hoard real goods. But the more people hoard real goods and less cash, the bigger the impact of constant real value of new money (and so bigger nominal value). Hoarding can be done by buying extra stuff ahead of when they normally would or waiting to sell things until prices have gone up. They keep less cash and more real goods. These two cycles can go on and on and prices keep going up.
Addiction to Monetary Heroin
The economy and government get addicted to cheap money. If at any point the cheap money is removed the economy and government will nearly fall apart. But over time a larger and larger dosage is needed. Eventually the patient dies.
Taxes for Bond Holders
Bond holders that are paid with money collected from taxes can expect to get the value of their initial investment back plus interest. However, when governments start printing money to pay bond holders the value of the money will be going down and holding bonds for years is a bad deal. Bond holders know this and can head for the exits when governments start doing this. The faster bond holders exit the faster the government will print. So this can spiral out of control in a bond panic.
Lenin's View
There is no subtler, no surer way to overturn the existing basis of society to than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner, which not one man in a million is able to diagnose. -As reported by Keynes
Modern Monetary Theory and Monetary Realism
In these theories hyperinflation is viewed as a political issue and not a monetary issue. They look for some trigger to blame the whole hyperinflation on. This may be a supply shock, a loss of productive capacity, corrupt or unstable government, or external factors like war. This will be some reason the government was deficit spending. While normally very into detail, even at the level of each debit and credit for monetary operations, when it comes to hyperinflation, they skip over all the detail of the mechanics of hyperinflation.
They always name the initial trigger after the hyperinflation has started and they know to go looking for one. They do not seem to have any ability to predict hyperinflation ahead of time and never discuss the mechanics of how it works or goes on for so long. If Japan gets hyperinflation, then they might trace things back to the tsunami and say that was the core cause; however, they could not tell you now if the tsunami will lead to hyperinflation in the future.
These two theories do not seem to help at all in warning when hyperinflation might start nor in really understanding how it works. All the other theories above can give you some insight to how hyperinflation happens. These are more like, "sometimes war causes hyperinflation", without talking about how or any of the steps that go on so you might be able to predict which wars would cause hyperinflation.
Since these two schools of economic thought seem unwilling to explain the mechanics of hyperinflation in their own theories, I will do it for them. In these theories government bonds are part of the money supply. Each time the government makes a new bond out of thin air and sells it, they add to the money supply. In these theories, if the government budget and deficit are out of control, then the money supply is also out of control. As prices go up the government needs to make more bonds to be able to handle the new higher prices. However, the more bonds they make the more prices go up. This spirals out of control, making hyperinflation.
Mix and Match
Note that you can mix and match parts from different explanations above to make your own explanation.
They are not contradictory but just different ways of talking about what is going on. It reminds me of the blind men describing an elephant. Maybe with all of these together we are getting close to understanding. Predicting the Timing
I think that you really can understand the mechanics of hyperinflation if you can understand all these different explanations. However, predicting when hyperinflation starts is a much harder problem, one that I do not claim to have solved, yet.
Others Views of Hyperinflation
As I think of other ways to explain hyperinflation I will add them. If you know of any more please comment.
Posted by Vincent Cate at 5:19 AM
http://howfiatdies.blogspot.com/2013/09/hyperinflation-explained-in-many.html
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