Hyper-inflation: where, why and when
This article looks at a prospective source of dollar hyper-inflation. The author is widely published on the history of money.
A source of dollar oversupply
Although printing was the source of the famous German hyperinflation in 1923 the printing press is not the only positive feedback which can de-stabilise money and tip it into hyper-inflation. There are other feedbacks threatening the dollar, in particular a risk from the melting of the frozen money tied up in the world's dollar denominated bonds.
Twenty years ago the world bond market was modest. At that time there was a much smaller demand for fixed interest securities from investors, and a much smaller supply from respectable borrowers. Since then several significant changes to the world financial scene have combined to accelerate the bond market through two decades of exceptional growth.
Breakaway bond growth
Inflation reporting : The first cause was the selectivity of inflation data. By concentrating on prices of manufactured retail goods at a time when technology was slashing the cost of production, and by eliminating from the statistics the asset-related costs of both retirement income and residential property, the impression was created that major currencies were not inflating, while in fact they were. Reporting a low inflation figure greatly improves the marketability of fixed interest bonds.
Tax breaks : Another cause was the widespread take up of government-approved and tax-generous savings schemes. Throughout the western world the consensus view became that formalised saving for retirement was so beneficial that everyone should be encouraged by the tax system to do it. This had the effect of creating a wave of savings money looking for an investment home - not always very sensibly.
Consumer credit : Then there was liberalisation of access to consumer credit. Previous generations had found that a natural debtor class could not resist debt when it was offered, but that their use of it was potentially destabilising as it tended to create a gulf between a rich minority and a poorer debt-ridden majority hooked on buy-now / pay-later. At best separation into classes of debtors and creditors produced volatile business cycles. At worst it triggered political instability, which is why it used to be carefully controlled.
Deficit finance : A fourth change was that governments stopped worrying about balanced budgets and financed the shortage of their tax receipts by issuing bonds - elevated to AAA status by the power of the state to create the money it might need to fund repayment. 'Reaganomics' was considered by many to be irresponsible at the time, but Americans became used to the consumer benefits conferred on them by it. Reagan's eight year administration ended having tripled the US public debt, with increases of about $200bn a year. Looked at now the Reagan Administration was positively thrifty, because the current deficit routinely increases at $500bn a year - about $5,000 per US household.
Corporate executive incentives : There was also a widespread change in attitudes to management participation in corporate capital - through executive stock options. Previously these had been frowned upon and discouraged because they tended to encourage managers to shoot at personal exit targets which suited them, while causing longer term damage to shareholder security and the industrial base of the country. The new enthusiasm for these incentive schemes encouraged managers to gear company balance sheets by issuing bonds, rather than safer equity, and so multiply their short term equity returns by exposing their organisations to larger long term debts, the disadvantages of which would surface only after the executives had successfully exited.
Monetary stimulus : At the same time government intervention in the economy grew to be exceptionally reliable. With increasing certainty big business knew that a threat of economic recession would be met by a splurge of cheap central bank money - useful to them to pay their debts, and to their customers to buy more products. In fact because of falling rates for most of the last ten years a bond redemption has been a bonus. Lower interest rates cause new bonds to be issued at lower coupon rates than the ones they replaced. This has provided a boost to corporate profitability; albeit a temporary one which reverses if future redemptions occur in a time of rising rates, such as might occur if lenders became wary of dollar inflation.
Securitisation of mortgages : Household mortgages used to be financed out of the accumulated deposits of local savers. Now it is likely that a given individual mortgage has been packaged together with others and sold to an investment institution as what is known as a mortgage backed security. This releases cash to the mortgage company which can be lent to more borrowers. As a result household mortgages are widely financed on the bond markets.
Trade gaps : Last but not least the determination of Asian countries to build their industrial bases has been enabled by holding their currencies down against the dollar. The direct effect is an accumulation of dollars in Asia, received in payment for their exports not balanced by imports, and this surplus works its way to the local central bank and is used to buy the sovereign debts of the importer's country - frequently the USA. The unwillingness by the exporter's central bank to sell those dollars incurs a risk of a later dollar devaluation, but it benefits the exporter by holding their own currencies down and therefore allowing the continued construction of an export led industrial base, and a transfer eastwards of the technology and means of production. (It is of no obvious benefit to the importer's economy except that people can live beyond their means for a while, and be trusted to vote for the democratic incumbent which best protects this right to consume.) Over the last few years this has produced a $3trn demand for dollar bonds - now held by foreign organisations.
These changes - and others - have combined to produce a very big world market for fixed interest bonds. The supply of savings money and opposing supply of apparently reputable borrowers combined to grow a mighty industry. The world bond market - the total amount of bonds issued onto recognised bond markets - has grown by more than 50 times in 20 years.
The bondholder's dilemma
Throughout that time analysts have been scratching their heads about money supply statistics. These dull figures were once considered a useful indicator of future inflation. Yet although the various measures of money supply have consistently shown high increases, the retail consumer price inflation has stayed low, held down by its technologically oriented statistical content.
What has happened instead is that twenty years of growing bond markets have steadily frozen the supply of money into dollar denominated debt, spent by governments, corporate managements and private individuals, and held in the form of bonds, as the suspended buying power of foreign central banks and the world's investment companies.
It is this glacial accumulation of world bond debt which threatens us now. It is - in effect - waiting on any set of events, like those of the seventies, which might cause savers to turn away from assets destined for fixed future redemption in dollars of doubtful value. Bonds are terrible investments in uncertain times because they inflate to no value in loose monetary environments, or default to no value in tight monetary environments. Because of this they depend on widespread confidence in the ability of central bankers to walk the fine line which holds money values steady.
Central bank fallibility
Collectively the central banks of the west have recently shown themselves able to do this. But what many people don't appreciate it that it has never been easier, and is about to get a lot more difficult.
Because they are only charged with keeping retail price inflation under control increasingly low-cost computerised production has provided central banks with a temporarily easy job. The natural competition between manufacturers would have greatly reduced the price of all the goods we buy. Instead, while technology has reduced production costs by 6% a year the central bank has taken back 8% by issuing unreasonably easy money which has settled into assets. This is how they have broadly achieved a 2% inflation target, and it is why savers can buy almost as many TVs as before, but not as many houses.
So the delicate balance which would ordinarily be very difficult to maintain has in fact been easy. If a central bank is free to pump 8% of new money into an economy each year there will be plenty for everyone. But the scale of cost savings in automated production is reducing now, and this makes the job of the central bank harder each year. The time is coming when they really will have to hold money supply down to keep inflation down.
Then it will be a delicate balancing act again - and one which will be made much harder by the weight of bond redemption capable of being released into the economy by savers so as to nullify any attempt the central bank might make to control the supply of money.
Much of this bond money is mandated for redemption when the boomer generation retires and seeks to convert its accumulated savings into consumption, which it will start doing in earnest over the next 5 - 10 years. Fund managers will increasingly see this coming, and will react by electing to switch from dollar denominated debt in front of the rush, rather than behind it.
It is a reasonable prediction that most savers will suffer. Being wealthy in retirement is workable only for a minority. When their numbers increase demand from boomer retirees will be unbalanced through the absence of their productive output. It must correct by sucking in imports and depressing the value of a fixed retirement income. At the same time wages must escalate to increase the differential between being unproductive and productive. Soon foreign goods and foreign travel become too expensive for the fully retired and those who don't work will lapse into subsistence - the normal condition for unproductive people. These are the types of forces which through the nature of economics appear to conspire against those who act behind the herd, and the result is that while they do frequently receive exactly what they were promised by their retirement plans it buys them very little.
As a direct example your author recently wound up the estate of a great aunt, who died aged 95 after a 35 year retirement. Having been fortunate in enjoying a retirement package which provided her full 1969 retirement income until her death, by 2004 the total annual revenue from it failed to pay her local property taxes. To her credit the subsisted happily enough.
Many parts of the world already know what this feels like. Most of them are paying the price of excessive earlier borrowing taken out at a time when money was easy.
For a digestible view of monetary disasters visit Galmarley.
Jul 21, 2005
Paul Tustain edits Galmarley, the popular free research site on gold. He recently sold London based SAM Systems - the specialist banking and risk management systems provider which he founded in 1990. He consults on risk management within the financial sector and is well known as a writer, publisher and TV panellist both on gold and the workings of the financial system. In 2005 he launched the Bullion Vault service - to improve the accessibility, security and affordability of professional grade gold bullion for private buyers all over the world.