How Deflation Creates Hyperinflation

I keep reading about the dollar being a "new multi-year bull market" and that the US is headed for "Japan style deflation". Frankly, it is a little tiring. The people making these arguments should know better.

Deflation VS Hyperinflation

Yes, there is debt deflation, and the overall money supply is shrinking as a result. However, those calling for "multi-year bull market" for the US dollar are insane. These individuals need to review basic monetary theory. The money supply is only one of three factors that determine whether prices rise or fall. The other two are the changes in the velocity of money and the real output of the economy.
The danger of hyperinflation lies in a dramatic increase in the velocity of money due to a loss of confidence, not in changes in the money supply.

Confidence and the velocity of money

When confidence in an issuing authority crumbles, money starts flowing through the economy at a feverish pace. For example, in normal, noninflationary times the money supply might be equivalent to three months of output, but in a period of hyperinflation it might drop to two weeks worth of output. Since increases in the velocity of money have the same impact on prices as increases in the money supply, a 1000% increase in the velocity of money (typical in any period of hyperinflation) is equivalent to a 1000% increase in the money supply. Due to its effects on the velocity of money, the ebb and flow of confidence have a much greater impact on the short-term trend of prices then changes in the money supply.

Deflation can create Hyperinflation

It is no accident that many of the worst periods of hyperinflation are preceded by deflation. In fiat currencies with high levels of government debt, severe cases of deflation cause a loss of confidence in the nation's currency by shrinking the economy and making the government's debt appear increasingly unsustainable. The loss of confidence then causes the flow of money to speed up as individuals become desperate to exchange cash for real goods as fast as possible, producing hyperinflation.

As an example of deflation leading to hyperinflation, consider the case of the Weimar Republic. In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honor checks, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the mark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%.

Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and the shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experienced one of the worst cases of hyperinflation in modern economic history. Billions of hoarded marks came out of hiding and entered the marketplace. The chart below tells the rest of the story.




How deflation creates hyperinflation

1) Deflation slows the speed of money to crawl due to fears about the deteriorating economy. The public hoards cash, or, in the case of the US, short term treasuries.

2) The slowing speed of money and debt destruction force the government to create huge quantities of cash to prevent prices and the economy from collapsing. However, because the public is hoarding cash (or short term treasuries), most of the money doesn't reach the real economy, which leads the central bank to print even more money. In essence, cash hoarding acts as a dam, preventing the enormous quantities of printed money from affecting prices.

3) Deflation weakens economy until it leads to a loss of confidence. With doubts about the government's solvency growing, the velocity of money quickly picks up speed, and a flood of hoarded cash comes out of hiding, entering the marketplace all at once and creating hyperinflation.

US stands on the verge of hyperinflation

Gold Backwardation signals that the next phase of the economic crisis, a rapid acceleration in the velocity of money, is about to begin. Right now, the flow of money through the economy is basically frozen: everyone is panicking into treasuries due to deflation fears. Negative yields on the 3 month treasuries are a sign of this.

Despite the glacial rate money is moving through the economy, the dollar has started to fall again, and gold has begun to rally. As this continues, investors will begin to questions the safety of treasuries, and sell them off. The money coming out of treasuries will add fuel to gold's rise and the dollar's fall. Once the dollar hits new lows and gold breaks convincingly over $1000, Investors expecting deflation will begin to panic, and a flood of money will come out of treasuries. It is then that hyperinflation will begin in earnest.

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52 Responses to How Deflation Creates Hyperinflation

  1. Enrique says:

    Neat & simple article about complex a situation that many of us expect, and as you say, is not undestood or is being covered by goverments, media and most analysts.

    Enrique, Barcelona

  2. Anonymous says:

    You clearly know more than I do on this topic, but I have a question. Wouldn't hyper-inflation be better than deflation still? As long as the government can control the interest rates, there is some influence on the value, right?

    When this hyper-inflation hits, just raise the interest rate?

    I could be way off though.

  3. Anonymous says:

    Really good quick analysis. Friend of mine who works at Citigroup Smith Barney has been saying that there has been a lot of interest in Germany's Weimar Republic hyperinflation recently... in other words, a bunch of wealthy clients believe that we are heading down that path, like this post says.

  4. Chris says:

    Excellent selection of chart to bolster your argument... Except that unlike Germany in 1919, the US has not experienced 1000% inflation in the last year. At the conclusion of this year, it's likely that our inflation rate will be in the 3-5% range which would seem to argue against 1000% inflation in the near future.

  5. "Wouldn't hyper-inflation be better than deflation still?"

    Depends on your financial situation. Here are a few examples:

    If you are drowning in debt and have a steady job, then hyperinflation is a Godsend as it will wipe out your debt.
    If you are living on fixed income, then it will be a nightmare as it will wipe out your income.
    If you are wealthy and have your money in cash/treasuries, hyperinflation will wipe you out if you don't react in time.

    "As long as the government can control the interest rates, there is some influence on the value, right?"

    Actually no, the government can only control interest rates by printing money. As an example, when the treasury bubble bursts, the fed will start buying treasuries (quantitative easing) to prevent interests rates (government's borrowing costs) from going up too much. These purchases will be funded with printed money, and so will fuel inflation.

    "When this hyper-inflation hits, just raise the interest rate?"

    The government owes over 11 trillion now, which is probably already more than our GDP. If the fed raises interest rates, it will increase the government's borrowing costs, making govenment debt appear even more unsustainable.

    -----------------------------------------------

    Christ:
    "Except that unlike Germany in 1919, the US has not experienced 1000% inflation in the last year. At the conclusion of this year, it's likely that our inflation rate will be in the 3-5% range which would seem to argue against 1000% inflation in the near future."

    One differance between Weimar Germany and today is that the US is the world's reserve currency, and we have been exporting our inflation for years. See Our biggest export: Inflation

    That system of exporting inflation will also break down when the world loses confidence in US debt.

  6. Anonymous says:

    I very, very concerned about the economy right now. One thing you didn't mention is that with this current bout of deflation, alot of investment capital has been scared off. Companies after suffering such a crippling loss on oil prices are loath to invest new capital in exploration and increasing supply that goes for ALL commodities. Oil had a 9 percent depletion rate this year alone. When this newly minted money hits this scaled back commodity market the short term effects are going to be explosive from an inflation standpoint for REAL things.

    Equities may rise, but commodities will rise much faster.

  7. Cameron says:

    Read Mises and Rothbard, folks.

    From 1800 to 1900 the USA developed rapidly and for that period had no central bank and dollars were redeemable in gold. The general price level fell slightly in that century (which this author would call 'deflation'), but I think you'd have a hard time proving that people had less wealth in 1900 than in 1800. A decline in general prices simply means that you can purchase more with each monetary unit. The dollars are more valuable. Sure, a company might show a lower number as a profit, but this is irrelevant if the purchasing power those dollars represent has increased. The same goes for wages. If your salary was cut to $2,000 a year but the price of a new car was $500, you wouldn't be complaining.

    Unfortunately the FED has been devaluing the dollar since 1914. In that time the dollar has lost 95% of its value. Basically, allowing money to be created by fiat (i.e. thin air) means that there will be more money but no additional output in the economy. As a RESULT, prices rise in nominal terms. Everybody has more money, but there's no more wealth.

    If wealth could be created by printing money, Zimbabwe would be the richest country on the planet right now.

    The federal reserve has been rapidly creating money recently. The newly-created money has gone to banks, but the banks are not lending it out for a couple reasons. 1.) The FED is paying the banks interest on it. 2.) The banks see many customers as a repayment risk right now. Essentially, current conditions are acting on the newly-created money as if there was an increase in the reserve requirement percentage.

    Because the banks are holding the money, it is obviously not in circulation. Because it is not in circulation, it cannot have an effect on the prices of goods and services in the economy. So for now, the recession, which is really a clearing of malinvestment, is forcing prices downward as people try to realign the capital structure to reality by adjusting how much they save and spend.

    However, once the banks start lending out all the money printed up by the FED, we will see high rates of price increase ("inflation").

    The government doesn't mind inflation because it is the biggest debtor and it gets to use the newly-created money first. In other words, Uncle Sam pays lower prices. By the time the new money filters down to the average person through wages, the price increases have already taken effect throughout the economy. Since there is a lag between the time when prices increase and when the average person gets to use the new money, what occurs is the destruction of wealth and savings because you have to spend a greater portion of your income to continue purchasing the same things you did before. Savings is the foundation of capital. Capital produces the goods we consume.

    Check out mises.org

    You don't need to be an economist to understand what's going on right now.

  8. Jake Peachey says:

    It seems theoretical intellectualism is the comforting process of taking real-world complexity to a simplified and reduced size; --allowing quicker and easier comprehension -- even though these theories are most likely to be wrong because theory cannot account for all real world complexity (The "sciences" of humanities including theories of economics and finance)
    We acquire a certain base theoretical framework externally --- that big picture outline--- for organizing the details into a seemingly coherent whole. After personal modification suitable to our temperament and aptitudes, we love the edifice of our theoretical creation --- never mind if facts contradict.
    Now, try to see if these solid historical facts can be explained within the theoretical framework that guides your perspective.
    In spite of all the circumlocution and commotion by President Roosevelt, the 1930s President never came close to ending the depression economy. The massive deficit spending of World War II did end the depression economy and set it upon the road to postwar prosperity.
    Consider World War II from an economic viewpoint. It was a huge public works operation financed by unprecedented deficit spending. It commandeered the productive capacity of this country and then destroyed this production in the battlefield. Why didn't this bankrupt the country? Theoretically, an operation like that should have bankrupted the country like a "closed system" business operation would have been bankrupted. (Fortunately, free-market capitalism at the macroeconomic level is "open system")
    One can only imagine the derision and criticism had anyone of stature, in the 30s, proposed such a program to end the depression economy. But there's no denying that World War II deficit spending did do it. Until one has a theoretical framework that can satisfactorily explain why World War II, not only did not bankrupt the country, but was the key factor in economic recovery --- all one can do is bewail the problem without offering any solutions that will work.
    "Open system" perspective: http://economics102.blogspot.com/

  9. Cameron says:

    To the previous poster, the Austrian school of economics perfectly explains not only why the depression occurred, but also why it dragged on for as long as it did. Check out a book by Murray Rothbard called "America's Great Depression." It's applicable to today's economy as well.

    That said, what WWII did was take 12 million men out of the labor pool and force them into service overseas. As a result, unemployment dropped to essentially nil. However, the workers and families who did not go abroad to fight could hardly consider themselves better off since virtually every industrial product was rationed. Food, steel, rubber, silk, aluminum, and countless more materials were dumped into producing airplanes, tanks, jeeps, bombs, bullets, and uniforms. These goods had no civilian use, i.e. they were strictly consumption goods, which is true of all government spending.

    To believe that war is good for an economy is to believe in the broken window fallacy made famous by Bastiat. (Not famous enough, apparently.) By the previous poster's logic, we should see boosts to the economy every time a hurricane levels a coastal city, or every time an earthquake causes extensive structural damage requiring billions to be spent for repairs. The more destruction, the more must be spent to repair it. Using this reasoning, we should carpet bomb our own cities! Then there will be reconstruction work for everyone and our economy will boom!

    Yes, war is good for some industries, but at what expense? In the example of bombing our own cities, we could expect the demand for construction jobs to skyrocket. However, what could those workers have been producing if they didn't have to REPLACE the destroyed capital (buildings & infrastructure)? Thus one should ask, if WWII had NOT occurred, what wealth would have been created instead? In lieu of building fighters and tanks and guns and bombs, American industries could have built cars, tractors, houses, radios, toys, and appliances. All of these contribute to the wealth of a society. What wealth was created by the bullets and bombs?

    World War II did not end the Great Depression. Rather, the END of WWII marked the end of the Great Depression. After the conclusion of the war, the government lifted all of the economic restrictions and allowed capital creation to continue in a way that government interference in the form of public works had prevented for the prior 16 years. Furthermore, the rationing of supplies meant that people had little choice but to save money. Savings is the basis for capital. Capital is the basis for future consumption.

    As for public works programs, they do not create wealth. They merely take money from some people and give it to others, minus a hefty fee for the bureaucracy of course. Paying people to dig ditches in the desert does not create wealth, unless you subscribe to Marx's labor value theories.

    I beg you all to check out mises.org. You will then begin to realize how much your Keynesian economics courses have led you astray from sound economic reasoning.

  10. Anonymous says:

    Good article.Though his conclusion is off .The velocity of money is the key.Most in the US are cash poor,so that flood likely won't happen.The government works programs take too long.Thus the lag time could be the factor.Look, oil down,dollar down.Oil influences other goods more so than anything else.Price of oil V. dollar,that's the key.

  11. Lyle Burkhead says:

    "The public is hoarding cash" is too vague. "The public" needs to be disaggregated. Most individuals are not hoarding money (except for a few mavericks like me). In fact most people are broke; they don't have any money to hoard. They are living from paycheck to paycheck, and trying to pay off their credit cards.

    Who, specifically, is hoarding cash and short term treasuries? According to a recent article by Puru Saxena, "Our research reveals that currently US$3.5 trillion is sitting on the sidelines, waiting to be invested." He doesn't say whose money this is, but it's not hard to narrow it down to the ususal suspects: banks, mutual funds, hedge funds, SWFs, and high net worth individuals. When they start to spend their money, what will they spend it on? Warren Buffett is buying stocks. Mutual funds will buy stocks if it looks like a new bull market is underway (that's all they can buy). Hedge funds and wealthy individuals may buy stocks, commodities, and real estate. This may cause a new bubble, but it will not cause hyperinflation.

    You can't have hyperinflation unless wages keep pace with prices. If prices go up but wages remain stagnant, people just can't buy what they want. The result is a decline in the standard of living.

    It is true that the US government is creating huge quantities of cash. This may or may not result in hyperinflation. It depends on how the money enters the economy. It depends on who spends it, and how.

  12. "You can't have hyperinflation unless wages keep pace with prices."

    Yes, you can. If the world loses confidence in the US and there is a run on the dollar, the price of imports will skyrocket. Retailers which import nearly everything they sell, like Wal-mart, will pass on the rising costs or go out of business. Just because wages remain stagnant doesn't mean hyperinflation isn't possible. The government will have to step (and print even more money) in to prevent people from starving.

  13. Toil says:

    I suspect there's a big difference between Weimar and today (so far). The Fed (owned by the banks, for the banks) has only pumped huge sums of money into banks, and those trillion$ are are sitting on the books in banks or at the Fed. So for now the Fed has considerable direct control, through reserve requirements, interest rates paid on excess reserves, treasury sales, etc. When and if all this money comes out to Main Street, there will be a chance that people would see too much of it.

    As for spending our way out of this problem, Marc Chandler of Brown Brothers Harriman tells why and how in "What If the Credit Crunch Is a Symptom?".

    He argues convincingly that the credit crunch is a symptom, not the cause. The real underlying cause seems to be a huge shift in national income over recent decades from real wages to business profits, just as it was back in the 1930's.

    Real wages have stagnated and fallen over the past 3 decades, while business profits and dividends have increased manyfold. Consumers responded to their falling wealth by increased borrowing. Business investment in plant and equipment (i.e. productivity) is not just labor saving, but also capital saving, so more capital (growing with profits) has pursued fewer economic opportunities, and it found its way into huge speculative bubbles including consumer lending.

    In this environment, renewed business investment is not a solution. The solution is a shift in national shares of income toward consumption. Please read and enjoy.

  14. Lyle Burkhead says:

    "The government will have to step (and print even more money) in to prevent people from starving."

    You are granting my point. If the government gives money to people to prevent them from starving, then their income goes up along with prices. I should have said you can't have hyperinflation unless incomes keep pace with prices. It would not have to be wages. If the increased income comes from the government instead of from their employers, that amounts to the same thing.

    Just printing money will not cause hyperinflation. To get hyperinflation, the government has to print more money and the money has to find its way to consumers. There are two cases: either the money enters the economy through the banks, and the result is another bubble; or the government gives money directly to the people, in which case the result is hyperinflation.

  15. Lyle Burkhead says:

    1. "If the world loses confidence in the US and there is a run on the dollar, the price of imports will skyrocket. Retailers which import nearly everything they sell, like Wal-mart, will pass on the rising costs or go out of business..."

    If the dollar falls against a trade-weighted basket of currencies, then the prices of imports will go up accordingly. This does not imply that prices of imports will rise exponentially; they could just rise to a new plateau. Expensive imports will not lead to Americans starving, since America is self-sufficient in food; America exports food.

    2. "...The government will have to step (and print even more money) in to prevent people from starving."

    This is not the model of hyperinflation you were talking about before, where "a flood of hoarded cash comes out of hiding, entering the marketplace all at once and creating hyperinflation." This is a different scenario.

  16. Evelyn says:

    "Expensive imports will not lead to Americans starving, since America is self-sufficient in food; America exports food."

    I do not that this statement is true since most of the food that in my supermarket and in the farmers market come from some other country.

  17. Anonymous says:

    very good article and even better discussion!

    Concerning the claim that a war is good to end a depression, I would like to add that this might even true be for the victor as a war that is won could be considered a "good investment" while a lost war is certainly a malinvestment and does not create wealth. The US not only participated in the war but earlier supplied their later allies against cash and dept. Moreover, US benefited in many other ways from the war and afterwards, that need not to be discussed in great detail.

    Concerning the conditions for hyperinflation, I believe one import point, that was already raised in the discussion is the distribution of money among the people. If there are some who have all the money but do not want to consume because they are already saturated and others who do not have any money - I cannot see how the flow of money should re-start, ie. how deflation should end. Only when - by whatever means - the distribution of money is sufficiently homogenized (for instance by "helicopter money" or - certainly less pleasant - by loosing a war with complete destruction of real wealth for ALL), money velocity might gain momentum and (hyper)inflation might start.

  18. Anonymous says:

    Hyperinflation is years away if ever. The money being printed by the fed pales in comparison to the amount of dollars being destroyed by the collapse of the stock market bubble, housing bubble, consumer debt bubble, banking fiasco, etc. Most of the dollars that are currently being printed are just being used to pay down debt by the banks and are not even making it into the real economy.

    The consumer is starting to get ready for the coming depression. The consumer is done and any extra money is being used for savings or to pay down debt. The is the beginning of a deflationary spiral that is going to last for several years.

  19. Anonymous says:

    I find many kernals of value in all of the coments. It is quite possible that velocity falls and deflation and failing industrial production pushes the world into depression. It is also probably true that at some point this reverses and the velocity spikes and hyperinflation (due to many countries juicing thier money supply to solve the problem) comes into play.

    The real fact is that recent years and decades are similar to a tight rope walker in good balance in calm and predictable conditions. When the winds begin to blow or the wire is shaken he (or she) begins to wobble and tries to self correct. Unfortunately the self corection often makes the situation more unmanagmenable- unless of course the wind becomes calm and the wire taut- resulting finally in a fall.

    Unfortunately, I fear that the global economic condition we have created is not going to calm itself soon, and any quick fix in this wind will result in a fall.

    The long term outcome of this is that the wealth creation machine that ran amonk is probably going to need to reboot via severe clensing of the system and most probably a complete reprogramming of the mechanics of finance, goverment and (gasp) regulation.

    I fear that the average person and probably many people of above average means will suffer a severe fall in their standard of living and financial security.

    Similar to a hurrcane that is outside the control of anyone on earth, we must accept our fate and persevere untill the changes (which are beyond our control) have taken hold and the winds calm in the aftermath.

    I predict a decade or more of instability. Unfortunately there is not much any one can do when the winds start to increasingly blow.

    All the economic theories, goverment control and policies and investment advice are sticks in the wind compared to the complex and powerful (and imperfect) economic system we have created.

  20. "Hyperinflation is years away if ever. The money being printed by the fed pales in comparison to the amount of dollars being destroyed by the collapse of the stock market bubble, housing bubble, consumer debt bubble, banking fiasco, etc. Most of the dollars that are currently being printed are just being used to pay down debt by the banks and are not even making it into the real economy."

    Let me ask you this: have even once thought about the other side of the equation? That is, have you thought about the US's economic output?

    When financing for our trade deficit falls through, our economic output will shrink by more than 75%. Do you believe that the money supply is going to shrink by more than 75%, even with all the money the fed is printing? Because unless it does, deflation is impossible.

    Also, unless you haven't noticed, the US manufactures less consumer goods then a third world nation. In third world nations, this usually means a terrible standard of living. In the US, this means we borrow money from China so we can buy cheap toys at Wal-Mart. Can you see how a period of deflation (ei: period of debt DESTRUCTION) might be a problem for a nation which DEPENDS ON DEBT to maintain its standard of living? Or do you believe the US can magically maintain its standard of living without debt or a real manufacturing sector? Is China going send us stuff for free?

    Sorry, if I sound a little irritated, but it is annoying to hear the typical "deflation=strong dollar argument". Do even know why prices fell during the great depression? One key reason was because the US had huge manufacturing overcapacity. Compare that with today, and you will notice a difference.

    Read my entry on *****Ten Major Threats Facing The Dollar in 2009***** for more info.

    "The is the beginning of a deflationary spiral that is going to last for several years"

    Do you really expect the world to send us stuff for basically free for years? Why on Earth would they do that?

    If you can explain to me how the US is going to finance its trade deficit going forwards, please tell me, because I just can't see how.

  21. Anonymous says:

    Nice article and discussion,so at least we all agree we are in a deflationary environment and severe hyperinflation is next,i guess what we differ is the timing as some see hyperinflation is around the corner and others see we are in a deflationary spiral for quite a while.
    I am purely technical in my market analysis and what i would say for the next several months the USD is going to gain strength once again and we could see the USD Index touch and extend the 100 level,i assume you can guess how that will affect the other market sectors,in short deflation will be the issue as we were early November and it will be worse,how i can relate this with what i can expect to be happening at that time is the US govt will continue printing unlimited US Dollars and doing there newly acquired hobby of bailing out every one,this is a trend that might continue till half way the year or even beyond,by then gold will have fallen and its price of $680 could be retested. At this point many key governments will make it obvious that necessary measures must be taken to try fight out the deflation environment,but for deflation to ease and inflation to set in i believe the US govt and other govt must halt the issue of bailouts and allow markets to stabilize on there own at some point.With time without govt interference investors globally will be able to decide what is good investment and what is not and slowly the markets will pick and with time a major USD sell off will ensue and inflation will be welcomed,and as the trend goes other advanced bubbles will be created an since we are always advancing i assume this bubbles will be tough to burst and possible the talk of that time will be "if and how the dollar will collapse and Euro or Yuan becoming the next global reserve currency".
    History will repeat itself. Its natural.

  22. Anonymous says:

    One thing being missed here is the 9% decline in oil production. This is a wildcard that will throw the system into some severe chaos for quite a while. The 'real' economy people talk about is not currency based, but energy based. We all know dollars won't make our cars go, gasoline will. When it gets scarce, the price will rise whether people have the money or not. Then the price of goods rises because it costs energy to create them. A contraction of 9% is catastrophic. that is a cumulative decline of 50% in 6-7 yrs - with no recovery EVER.
    When the world begins to wake up to that reality - probably in 2009 or 2010 - who knows? but people will begin to realize that things like FOOD and HEAT are a lot more critical than paper and electronic digits. When the wealthy realize that - much sooner than the great unwashed - all that sideline money will flow into commodities and - presto, chang-o - hyperinflation or some near semblance of it.

  23. Anonymous says:

    Contrary to what you assert, hyperinflation is caused by expansion of the money supply. There were no trillion mark notes in circulation in 1922, and they did not print themselves.

  24. Skaven says:

    Just read your article, and there is one huge flaw in your thesis.

    The Germans did NOT print marks to fight deflation!! The Germans printed marks in order to buy gold, so that they could give it to the Allied powers are part of the terms of their defeat in WW1. They owed more gold in reparations then they had, and they needed to get it somewhere.

    So, they printed the marks they needed, bought gold and paid their debt. They Allies then used those marks to buy German resources and cheap labor, thus flooding the nation with the currency.

    That's what really happened. Get your facts straight, please.

  25. andy h says:

    Great article. Perhaps you should address what "Skaven" said in the previous post. It's not "one huge flaw in your thesis" on the face of it, just maybe you have made a historical blunder?

    As for the various theories of "the real economy" versus the banking system, to my mind this is part of the nonsense that has got us to the current stage of the crisis. Sure there are people who control huge pools of financial capital, but they live in the same economy as everyone else. They will continue to mobilize that money as suits them and if that means they toss the United States government (via treasury dumping) under a bus then that is exactly what will happen.

    Jim Sinclair gives an interesting view on the hyperinflation. He is adamant that it can happen in a contracting environment where wages are declining. I think this also goes some way to address the argument by Lyle Burkhead "You can't have hyperinflation unless wages keep pace with prices."

    Actually, this is spliting hairs I think, the real question this: Will confidence in the dollar collapse to the point of no return?

    This is not a mathematical problem based on the velocity and/or quantity of money, this is a basic problem of confidence! The dollar is not the only currency in this condition either, the entire international monetary order is in doubt. For one thing the businessman cannot rely on his national currency as an adquate and stable unit of account. Huge distortions have been created and are in progress: massive fraud (direct bailouts, insider trades in zombie banks, naked shorts, leverage of fractional reserves) and massive volatility.

    I think the answer is yes, the dollar (and GBP) has reached a point of no return. Regardless of the numbers the outcome will be a dramatic drop in the buying power of the dollar. The big funds and the smart money will buy gold and tangibles of necessity. The commodity sector will recover from deleveraging and demand will stabilize just as supplies are starting to dwindle.

    As for the people of the USA, "the public"... they will fall back on a primitive domestic economy, where once they commanded the real wealth and output of other nations they will now be generating producing their own basic goods. I have no doubt that they will be forced by the politicians to accept some form of fiat money, but for the most part it is fanciful to expect that the public will have any desire to hold dollar balances when they finally experience the inflation that is building in the system.

  26. Philip says:

    It seems a lot of the comments miss one of the main points of the article: hyperinflation does not arise from inflation. It arises from a loss of confidence in the currency. Another way to say this is that money velocity can be caused by a number of factors and the one linked closely with hyperinflation is loss of confidence.

    I suppose hyperinflation could be classed as a type of inflation, but in historical terms they may be separate phenomena, insofar as they are usually caused by different factors.

  27. Skaven said...
    Just read your article, and there is one huge flaw in your thesis.

    The Germans did NOT print marks to fight deflation!! The Germans printed marks in order to buy gold, so that they could give it to the Allied powers are part of the terms of their defeat in WW1. They owed more gold in reparations then they had, and they needed to get it somewhere.

    So, they printed the marks they needed, bought gold and paid their debt. They Allies then used those marks to buy German resources and cheap labor, thus flooding the nation with the currency.

    That's what really happened. Get your facts straight, please.

    Skaven, did you bother to do any research before making your baseless claims? Any research at all?

    Because if you HAD bothered to spend fifteen minutes looking up about Weimar Republic, you would know your argument makes no sense:

    1) Germany's crushing debt WASN'T caused by the treaty of Versailles, but from financing the war itself. Weimar borrowed massive sums for war bonds, counting on victory to recoup debts from allies. This massive war debt was a much bigger burden on Germany then the treaty of Versailles. So, at best, you can claim the treaty Germany's enormous budget deficit worse.

    2) Even excluding the interest payments on its debts (treaty and war bonds), Germany was still running a large budget deficit and trade deficit. Sound familiar?

    3) Weimar's real problem was the gap between expenditure and income. Like the US today, Germany didn't like the solutions to this problem: more taxation or spending cuts. Neither of these options was popular as they would alienate support by increasing unemployment and depressing the economy. So Weimar kept spending money by running the printing press, just like the US today.

    The main causes of Weimar hyperinflation were overborrowing during the war years, continuous overspending by government, refusal to raise taxes, and Germany's large trade deficit. The reparations issue was only a contributory factor which made the inflation worse, not the primary cause.

    Do research some research next time!

  28. Anonymous says:

    The reason for the deflation is that people have borrowed up to their eyeballs. A lot of consumers and businesses are on the edge of bankruptcy. They have no money to spend on discretionary items. In addition, savers have seen their portfolios decline in value, which suppresses spending. That is also deflationary.

    The deflationary trends are self-reinforcing and can continue for a long time, unless counteracted by printing money. I'm no fan of the Fed, but this is one of the rare occaisions where it can do something helpful.

  29. Dissenter says:

    Someone in here said that commodities (more so than equities) would be the best investment in an inflationary scenario. But won't the stocks of commodity companies do just as well as investing in the commodities outright?

  30. Anonymous says:

    Love the previous posts. I think George W Bush did a fine job driving the US economy off the Cliff. I am optimistic about President Obama but am quite concerned with his lack of real world business experience.

    Maybe I am just naive but in my opinion we have far too many people consuming far too many resources and the various economic systems are incapable of distributing these resources in their various forms.

    If so that would make sense why World War 2 there was a peacetime prosperity i.e. a lot less people.

    I am not advocating any wars! maybe just better family planning. Would love some comments on my thoughts

  31. Anonymous says:

    Very interesting discussion which proves, as usual, that if you ask 258 economists for an analysis of an issue, you will get 364 answers...now, someone tell me what do I buy ? sell ? ...and when ? :)

  32. Martijn says:

    Be aware that this article makes quite some assumptions. The basic theory seems correct, a lack of confidence in the paper value might increase the circulation of money and that will certainly cause (hyper) inflation. However, it is not a proven fact that people will lose confidence.
    Although today differs from the 1930s, there was deflation back then just as today. There also was a new deal and government spending, however, we did not experience hyperinflation caused by increased money velocity. One could argue that WWII did not allow for the scenario to play out completely, but at least for a decade hyperinflation was not seen.
    Besides that the money currently being printed is not hoarded by the public at all, it is used to keep massive debts afloat instead of defaulting and shrinking money supply. So, the cash is not used for hoarding, but rather to maintain the amount of money in circulation from shrinking.
    In order to prevent people loosing trust some extra measures have also been taken, e.g. capping the gold price and boosting stock performance by means of the plunge protection team.
    On top of that the government could (although one could argue that the will) decrease money supply should inflation arise.
    The facts are that we are currently in a deflation just as we have been in the 1930s, and that the scenario of this deflation causing hyperinflation is far from certain to play out.
    If one believes hyperinflation is certain to visit us, borrowing as much money as possible seems to a considerable option besides owning some gold (and guns and whiskey haha).
    So:
    - hardly anyone is hoarding cash since debt is omnipresent
    - freshly printed money is used to keep the amount of money in ciculation from shrinking to rapidly as a result of defaulted loans.
    - for velocity to increase confidence has to fall dramatically, which is not guaranteed
    - to preserve confidence some other measures are taken such as capping gold prices and plunge protection team (although I cannot prove this, off course)
    - in the 1930s deflation lasted for years without curbing to (hyper)inflation, so history has proven that scenario viable already

  33. Chumba Wamba says:

    Just some things to keep in mind:

    1) The fundamentals of the US economy and the US dollar are very different today than they were in the 1930s during the first Great Depression. Analogizing today to then suffers inherent flaws and should be carefully considered (if not avoided outright).

    2) As Eric pointed out, hyperinflation occurs at a nexus of increasing currency and decreasing confidence. Once there is a cross-over, hyperinflation is a given.

    And a word of advice: mainstream economic thinking got us into this mess. What makes people think that that same mainstream economic thinking will get us out? It's time for the Keynesians to step aside and let rational and valid economic principles take root. If they refuse, we will insist. If they remain obstinate, bullets will take care of the issue.

  34. Martijn says:

    In my opinion people pay way to little attention to historic lessons. In our consumption society most people are only focus on their own wants and needs for the short term, and lots of people are arrogant enough to think they know it all. In my opinion now is the time to listen to historians, instead of politicians or economists.

    The similarities between the current situation and the 1930s are plentiful:
    -The Kondratieff wave can be seen as being in fall in both periods
    -Both periods started with relatively high inflation (do not trust the official statistics on this, real inflation was much higher in the 2000s)
    -Al this inflation went to housing and the stock market in both periods
    -Taxes were lowered drastically
    -Individual and company debt rose to massive hights
    -New technologies came up (electricity in the 1930s and internet in the 2000s)
    -There was massive fraud (2000s e.g. Enron, Parmalat, Madoff, Ahold etc, 1930s e.g. Ivan Kreuger)
    -A "permanent high" was reached in the stock markets (new era and new economy)
    -1930s first decline was 2000s decline, afterwards both markets recovered about 50% and then declined again. The massive credit growth was the reason for the longer period between both phases in the 2000s
    -In response central banks lowered interest rates maximally in both periods
    -After the 1930s power shifted from the UK to the US. Now it will (most likely) shift from the US to China

    So there are quite some historical parallels and they can provide quite some useful information for the current crisis. However most people seem hardly aware.

    That said I confirm that there are also major differences between both periods, and what happens now will centainly not mirror the Great Depression exactly.

    As Mark Twain said: history doesn't repeat itself, but it sure may rhyme.

    So, I am not denying the (severe) possibility of hyperinflation, but I reckon it is wise to take history into account when studying scenarios.

  35. killben says:

    If you are living on fixed income, then it will be a nightmare as it will wipe out your income.

    What would be your suggestion here .... move to gold as all currencies are being debased

  36. Anonymous says:

    Question:

    "When financing for our trade deficit falls through, our economic output will shrink by more than 75%."

    Could you please clarify this? First, China stops financing our ability to purchase their imports, which reduces our imports, thereby reducing the trade deficit. How does this result in lower economic output?

  37. ajit says:

    Here is my (Indian sitting in India) take on Deflation Vs Hyperinflation.
    I tried using game theory to predict what could be the best way out for US out of this current mess?

    The conclusion is the "US devalues Dollar" which leads to
    1) Wiping out all the debt denominated in USD (not bad mortgages again have equity)
    2) Devaluation of USD would lead to competitive devaluation world wide (ahem commodities is the way to go)
    3) US banks BS correct itself, as the assets inflate while debt deflates. Surely they would suffer on their loan book but then they made big mistakes as well
    4) Solvency issue gone, new reserve currency would be proposed

    I would argue that 1930 deflation was correctd due to dollar devaluation than WWII. Historically folowing devaluation equity markets outperform by more than 50% if you buy couple of months following Dollar crash/devaluation.

  38. Robert says:

    Hi Eric:

    Great Article !

    One question for you.

    What's the potential spill-over effect on non-dollar currencies like Euro - who's economies are heavily reliant on exports to the US ?

    Should the US government declare bankruptcy - one assumes what ever is left of the Euro zone's export market in North America - would disappear - impacting the Euro too.

    Any ideas ?

    Robert

  39. Anonymous says:

    The credit explosion has now become the credit implosion.
    The velocity of the turnover of money is FALLING at a rapid rate.
    The US Gov only prints a certain amount of greenbacks each year.
    Deflation is occuing and will continue on for a few more years.
    The world is SHORT of money.
    The FED is trying to reinflate the economy as is every nation.
    So much money has been lost (poof - its gone) around the world that it affects people in such a manner that they do less and this affects most businesses and that affects each countries economy.
    High rates on inflation will come after DEFLATION has run its course.

  40. Howg says:

    Why are these debates always between the Austrians and Keynesians?

    Can you address those theories put forward by Helen Brown at http://www.WebOfDebt.com?

    There are apparently historic examples of fiat currencies that did work w/o causing inflation, (unless she is wrong about that).

    That all of our money is debt, and the interest in never created, surely must be significant, (luckily, I have never been properly educated to think otherwise). We really do need a monetary system that creates money rather than debt.

    The rationale that GDP, (our exchanging notes of debt we call money), can create real wealth is entirely bogus IMHO. The entire system is a Ponzi scheme, depending on tomorrow's principal to pay off today's debts. Yet I have never heard an economist address this, nor have I succeeded in even getting a response from the many I've written to.

    See also: http://www.transaction.net/press/interviews/lietaer0497.html

    "...Money is created when banks lend it into existence. When a bank provides you with a $100,000 mortgage, it creates only the principal, which you spend and which then circulates in the economy. The bank expects you to pay back $200,000 over the next 20 years, but it doesn't create the second $100,000 - the interest. Instead, the bank sends you out into the tough world to battle against everybody else to bring back the second $100,000."

    As to what will happen next, I have no idea whatsoever...

  41. I have a question. At the beginning of this article you said "The danger of hyperinflation lies in a dramatic increase in the velocity of money due to a loss of confidence, not in changes in the money supply."

    Yet, later in the article you say that " The slowing speed of money and debt destruction force the government to create huge quantities of cash to prevent prices and the economy from collapsing."

    So then, changes in the money supply DO cause hyperinflation. If the government didn't react to hording and a slow down in the velocity of money by printing more and more, then there wouldn't be hyperinflation. We'd just have deflation.

  42. Anonymous says:

    As foreigner (frenchà, let me give you my analysis.

    As explained and agreed by most of you and myself, Hyperinflation can come only from lose of confidence in US economy. This risk is gettting higher, but US governement makes sure that it will not happen. Why ?

    Because, recently when US gov decided to buy T-bond (ie to print virtuals notes to be simple), the risk was high that the biggest USD owners that are China and dollars producers were selling their money stocks, which would lead to hyperinflation (and I remind you that in 2009, money is extremely volatil, 1000 more times than in 1930). So first, they meet those parties and made sure that they will not act in this way. Making sure they keep their dollar, will continue the dollar to be the global currency used for everything world wide, and nobody can believe that US economy can crash.

    Hyperinflation would mean the US economy crash. The consequence sould be terrible for world. And certainly war, impossible to guess, but it would be really the beginning of huge troubles for years.

    On our side, in Europe, it is getting harder to keep the same money between country like France which has the same strategy than US, and Germany which has reduced its debt.

  43. Anonymous says:

    SAME WITHOUT MISTAKE :

    As foreigner (french), let me give you my analysis.

    As explained and agreed by most of you and myself, Hyperinflation can come only from lose of confidence in US economy. This risk is getting higher, but US governement makes sure that it will not happen. Why ? How ?

    Recently when US gov decided to buy T-bond (ie to print virtual notes to make it clear), the risk was high that the biggest USD owners that are China and petrol providers were selling their money stocks, which would lead to hyperinflation. So first, they meet those parties and made sure that they will not act in this way. Making sure they keep their dollar, will continue the dollar to be the global currency used for everything world wide, and nobody can believe that US economy can crash.

    I remind you that in 2009, money is extremely volatil, 1000 more times than in 1930. Hyperinflation would mean the US economy crashes. The consequence could be terrible for US and the rest of the world. And certainly war, impossible to guess, but it would be really the beginning of huge troubles for years.

    On our side, in Europe, it is getting harder to keep the same money between country like France which has the same strategy than US, and Germany which has reduced its debt. But finally, this is just exchange rate question, and I strongly doubt that modern country could get hyperinflation.

  44. This article focuses on the minor increase in purchasing power of the mark and completely avoids any reference to its rapid devaluation from 1919 to 1920. Presumably, though I don't have any data, the rapid devaluation was caused by a considerable increase in the money supply during the war years. On a semi-log plot, the devaluation does not match the 1919 rate, again, until mid-1922.

    You have completely ignored the effects of money supply and fractional reserve banking, although you are correct that confidence is an important factor. The lack of confidence in the currency comes about as a result of the government/central bank pumping money into the economy. The US is currently the world reserve currency (like gold was during the time in question). What will happen when the 100% increase in base money hits the market? Will the Fed be able to slow down the rate of increase as the base money expands rapidly through the system?

    We are likely on a course for hyperinflation, but it is the political reaction to the reduction in growth of the money supply that is the cause, not the fact that the money supply slows in growth.

    I agree, the Market Skeptic should read Mises and Rothbard. Even if he just read Hayek, he would be better off. You're gut instincts appear to be good, but you need to understand the fundamentals a little better.

    I hope you continue to learn and grow. You are young and have plenty of opportunity to do so.

  45. Elliot says:

    Sorry but that article is way off base. Any comparison to Weimar Germany that does not reference the completely crippling reparations demanded from the Allies against the German powers has to be taken with a grain of salt. Germany wanted inflation in order to enable the payment of these reparations. It was not an effort to stimulate the economy that crippled Germany. Before inflation took hold, Keynes wrote a lot about the potential for instability resulting from the Treaty of Versaille...it's worth a read.

  46. Exactly what is the difference between running the printing presses vs. devaluing the dollar? Devaluing against what? Other fiat currencies?

  47. bpk7131969 says:

    All the technical talk in the world wont disregard the debt the state and feds are in, doesnt take a college grad or some complex monetary theory to predict the outcome the monetary dire straits we are in, Ill keep packin in the gold and silver, on hand by the why, not giving my cash to some thief on Wall st who only holds about 10% of what he has out on paper, we are at the end of a cycle, all the complex math calculations in the world wont pay off this debt!!! FACE IT!!!

  48. Vincent Cate says:

    I have been trying to organize info on hyperinflation and inflation vs deflation at:

    http://pair.offshore.ai/38yearcycle/#hyperinflation
    http://pair.offshore.ai/38yearcycle/#deflation

    -- Vince

  49. wg202 says:

    So where is the hyperinflation?

    We're still seeing some risk of deflation.

    The government did not increase the money supply. Instead, it sold debt and a multi-year stimulus spending package.

    Now the gold bugs are saying to reduce the deficit... but that doesn't seem wise given our high rate of unemployment. A cut in spending would reduce the velocity of money - because the unemployed would not spend money, and can't acquire debt.

    The middle class is refusing to acquire debt, due to job insecurity. Are businesses going to do it?

  50. برامج says:

    i agree with Tim Horton thats the only right comment i read انفجن

  51. anonymous says:

    It took from mid 1918 to mid 1922 for the inflation rate to go into hyperinflation, so 4 years. Since the FED started printing money in late 2008 it has been about 2.5 years (april 2011), so before the autumn of 2012 we should see the hyperinflation arrive and a nice build-up until then.
    http://en.wikipedia.org/wiki/Hyperinflation_in_the_Weimar_Republic
    Straight from the horse’s mouth, Fed St. Louise: http://research.stlouisfed.org/fred2/graph/?chart_type=line&width=1000&height=600&preserve_ratio=true&s1id=BASE
    Since the summer of 2008 the FED has diluted the dollar to approximately one third which means it has a long long way to fall, if the FED stopped printing money today the prices should rise 3 times in the next couple of years.

  52. Bmoneywise says:

    So now that we are in a flat place in our economy are we goin into deflation soon? Will the price of gold go down before it explodes? I speak of this on http://www.insure-db.com but believe deflation will be short lived and hyperinflation long lived.

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