- Causing HyperInflation

Hyperinflation isn’t a monetary phenomenon, it’s a political one. Inflation – now that’s monetary. But even a statement as simple as that one seems to ruffle a ton of feathers. Have a look at this post by Kevin Williamson. He rightly says that inflation causes high prices and not the other way around. But, if you read the comments there are a lot of smart people who adamantly disagree with him.

A good friend of mine who specializes in energy development projects and manages hundreds of millions of dollars in private equity feels exactly the same way. Keep in mind, he isn’t some academic with no stake in the game, arguing the minutiae of the CPI scoring or debating the semantics. This is a guy with 20+ years experience managing both his own money and the money of others in the capital markets. He’s made a fortune for himself over the years and billions for his investors. And he insists that you can’t have ‘inflation’ without rising wages. My counter argument to that was – tell it to the Chinese.

Milton Friedman, from whom I take my view, claimed that inflation was exclusively a monetary phenomenon. The money supply increases and prices will rise to adjust for it. “More money chasing fewer goods” is the one liner they used back when I was learning about it. And by that definition, Kevin Williamson is absolutely right about global inflation in commodities. I think he’s wrong about that being a “global no vote” on monetary policy, but that’s a different topic. As for inflation, he’s dead right.

Mind you, doing something about it is another story. When economists are trying to set policy they like to exclude food and energy because the prices of those items are much more volatile. Lots of things can increase oil or corn pricing even without inflation being a factor. So since they try to look long term when setting policy, economists have been trained to exclude the volatile items from the index in an effort to exclude their non inflationary effect. Violence in the Middle East may raise oil prices, but you don’t necessarily want to change your monetary targets because of it. The markets are not sealed in a bubble, and mathematically isolating the cause and effect of price movement isn’t completely possible, especially for more volatile items.

So inflation is a monetary phenomenon, but hyperinflation really isn’t. Let me illustrate with a little thought experiment. As of December 10th, 2010 the current M2 (the ‘money supply’) was about 8.3 Trillion. Allowing for some definitional liberty, lets call that all the ‘dollars’ currently printed. Suppose the Federal Reserve chose a day when all markets were closed and where no other news events occurred to announce a change in the target of M2. Suppose on the next business day they were going to expand their balance sheet until M2 was equal to 16.6 Trillion – twice the current number. What do you imagine would happen to the value of a barrel of oil, or a bushel of corn, or a gold coin? In other words, by that metric what would ‘inflation’ be?

Well there is a quantitative process for determining that, and the starting point for it would be to double the ‘price’ of everything denominated in dollars. That wouldn’t be the only effect. The markets will also take into account the reason that the Fed made that decision. They would look at the why’s and where’s of the decision making process in an effort to determine the probability of them doing it again - or undoing what they just did. They’ll discount that probability of further action in either direction, and the markets will overshoot or undershoot the “double” number by the consensus of that estimate. From there it might also include additional ‘error’ based on deleveraging or momentum, or lots of other things. But that would be the basis, and inflation over that period would be something like 100%. That’s VERY high, but it’s not hyperinflation.

My point is, even if the Fed did something as dramatic (and deranged) as doubling the money supply, absent other input it wouldn’t mean that we descend into hyperinflation. Inflation would be stratospheric, but we wouldn’t see the breakdown of confidence in the process without additional data. This is because hyperinflation is really an issue of discounting. It happens when market participants look at how the decisions are being made about the money supply and conclude that they aren’t being managed in a rational way. They then lose confidence in what amounts to the political system making the decision, and the currency is devalued to infinity.

Saying that a monetary system isn’t being handled rationally isn’t the same thing as saying that you disagree with how it’s managed. Whatever politicians say, the markets clearly believe that the Fed’s process for deciding monetary policy is thoughtful, considered, and based in reality. In fact, even if you put Howard Dean in charge of the Federal Reserve (if you can think of a public figure whose economic view is more fully divorced from reality than Howard Dean I’m open to alternatives) he will still be constrained by a functioning political system. And those constraints will tell market participants where the limits of his craziness will be.

I’m not saying that it’s impossible for the US dollar to hyper inflate. I can imagine several circumstances that may cause that sort of consequence. But none of them will be Ben Bernanke’s fault. Printing money won’t do it, only dysfunctional decision making will. And in the case of the US, that decision making would have to convince the global markets that there is no way for us to return to a rational fiscal policy. (For more detail on that see my previous post) But given the stake holders (and what they will do to our politicians if they continue to act like children when the next crisis comes) I think it’s unlikely to happen. Possible – but I’m betting against it.

But to put it off on Ben Bernanke and the Fed is to misunderstand the role of the money supply, and the nature of inflation. The truth is, inflation and hyperinflation are really two different things. A good analogy is that inflation is like the common cold while hyperinflation is like hemorrhagic fever. The common cold is a nuisance, but it’s rarely fatal for those who are basically healthy, while hemorrhagic fever kills the fit and unfit alike. They are both illnesses, and both can involve a fever. But there is really no reason to believe that one will inevitably lead to the other.