Is U.S. Hyperinflation Imminent?
|May 1st, 2014, 07:40 PM||#1 (permalink)|
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Is U.S. Hyperinflation Imminent?
According to renowned economist Marc Faber, hyperinflation in the U.S. is a certainty within the next 10 years. Mr. Faber has correctly predicted some of the most important financial events in the modern era including, the stock market crash of 1987; the rise of oil, precious metals and other assets in the 2000′s; and on Fox News in February 2007, he said a U.S. stock market correction was imminent. The market peaked six months later. Is Mr. Faber correct this time? Is U.S. hyperinflation imminent in the next 10 years?
In this article, we will discuss the effects of inflation and hyperinflation, consider an example of hyperinflation and discuss the possibility of this occurring in the U.S. One thing is certain, if hyperinflation does materialize, it would be devastating to our economy. Let’s begin with inflation.
The Fed is the primary catalyst for inflation. Moreover, it actually attempts to create a low to moderate level of inflation. Why does the Fed want inflation? Because inflation is a signal of a growing economy. Additionally, if inflation is too high, the economy will suffer. If it’s too low, deflation becomes a threat. Therefore, low to moderate inflation is the goal.
Inflation may be defined as “A general rise in prices” and occurs when demand outpaces supply. Actually, there are a couple of ways inflation can manifest and the Federal Reserve’s monetary policy lies at the heart of both. For example, when the Fed lowers interest rates, money is cheaper to borrow. Next, when the Fed expands the money supply, money is more plentiful, which again, makes it easier to borrow. Finally, when the Fed reduces bank reserve requirements (i.e.: The percentage of each deposit which must be held in reserve at the Fed), banks have more money to lend. All three create an environment which makes money more plentiful and cheaper for consumers and businesses to borrow. Of course, this assumes consumers and businesses are willing to take on debt. Another consequence of a significant expansion in the money supply is the devaluation of the currency. In essence, when there is a substantial increase in the supply of an item, including currencies, its value declines. Hence, it takes more dollars to buy the same goods and services. In a literal sense, inflation is the result of a decline in the value of a currency. Therefore, if Fed policy is successful, the expectation is that demand will rise, companies will expand their workforce and/or spend more money on technology to meet the increased demand and the economy will grow. However, if demand increases too rapidly, inflation will result.
Although inflation is defined as a general increase in prices, during such periods, prices on some items may rise while others may fall. Therefore, we shouldn’t presume that if home prices rise; food prices, auto prices, etc., will also rise. Actually, prices on specific items rise and fall based on the Fed’s monetary policy plus supply and demand for the particular product or service. For example, let’s assume XYZ Company produces widgets and has a monopoly on them (i.e.: no other company is legally allowed to produce them). Further assume this company makes 8,000 widgets each month, but has the capacity to produce up to 10,000 if necessary. In this case, the company’s “Capacity Utilization” rate (i.e.: the company’s current percentage of maximum capacity) would be 80% (8,000 / 10,000). However, if demand were to suddenly increase to 15,000 widgets per month, XYZ would have to expand its facility, hire more staff and/or purchase technology to meet the increased demand. This would cause the price per unit to rise (at the production level), which would necessitate a price increase to the consumer in order to maintain the same margin of profit. If inflation became too elevated, it would be called hyperinflation. Let’s look at this now.
Hyperinflation is much less common than inflation. Unfortunately, there is no specific numerical definition for hyperinflation. However, there is some consensus. For example, a few economists suggest that an inflation rate of 50% per month would constitute hyperinflation. Using this rate, a junior cheeseburger deluxe at Wendy’s, which costs about one dollar today, would cost $130 a year from now and nearly $17,000 in 2 years. Needless to say, hyperinflation is a destructive force which is best avoided. Could we actually see hyperinflation in America? Has hyperinflation occurred frequently?
The Nineteenth century was the century of deflation, whereas the Twentieth century was the period of inflation. Hyperinflation occurred as many as 55 times over the past century. Notable countries include: China, Russia, Brazil, Germany, Argentina, Poland, Chile and others. Could it happen in America? Many experts say no.
Because the U.S. has a very proactive Fed, and there’s such a large amount of historical data from countries that have experienced hyperinflation, we should be able to learn from the past mistakes of others and avoid it. However, since inflation and hyperinflation are triggered by an excess of currency, which is not backed by gold or any other substance of value (i.e.; called “fiat” currency), there is no limit to the amount of dollars the U.S. can print (though we don’t print that much actual paper these days). Therefore, we need to briefly discuss the gold standard.
There are a few different types of gold standards. However, in the interest of brevity, we’ll only skim the surface on this subject. Generally speaking, when a country adopts a gold standard, the amount of currency it may issue is limited by the amount of gold it holds in reserve. During times of war, a country’s need for capital increases, so abandoning the gold standard allows a country to expand its money supply to finance the war. This has been the typical path for countries during wartime. Today, there are no countries on the gold standard. In the absence of this, again there is no limit to amount of currency a country may print. This can be problematic, especially in smaller, developing nations. The absence of a gold standard was a key factor in one of the worst cases of hyperinflation in history. I’m referring to Germany following WWI.
Germany’s Hyperinflation After WWI
When WWI began, Germany abandoned its gold standard in order to print more currency to finance the war. When the war ended, Germany admitted they had started the war and agreed to pay reparations to various countries, with France being the major beneficiary. The details were included in the Treaty of Versailles, the document which formally ended the war. The amount Germany was required to pay was enormous. In fact, the total was close to 226 billion gold marks (approx $846 billion in current U.S. Dollars). After it became evident that Germany was unable to meet this demand, in 1921 the burden was reduced to 132 billion marks, the equivalent of $442 billion in today’s dollars.
Due to the war, Germany’s economy was in shambles. Moreover, with many of its factories in ruin, its production capacity was severely reduced. Hence, even the reduction to 132 billion marks was well beyond its ability to repay. However, to help assure compliance, France and Belgium deployed troops to Germany from 1923 to 1925. During this period, Germany’s central bank, the Reichsbank, issued a massive amounts of marks to repay its debt. However, because Germany had abandoned the gold standard, its currency was backed only by the full faith and credit of its government. Between this monetary explosion and the loss of confidence in its currency, the German mark experienced a massive decrease in value, which resulted in severe hyperinflation. To better grasp the situation at that time, prices doubled during the five years from 1914 to 1919. They doubled again in only five months in 1922. In 1914, the ratio between the mark and the U.S. Dollar was 4.2 German Marks to one dollar. By 1923, it took 4.2 trillion marks to equal one dollar. The German currency had totally collapsed. This also contributed to a brief, but sharp recession in the U.S. (August 1918 to March 1919).
Who Benefits And Who Suffers From Inflation And Hyperinflation?
The beneficiaries of high inflation include any individual or entity who has borrowed money at a fixed rate. High inflation also benefits investors who own commodities, and businesses that derive a significant portion of revenue from exports. Who loses with inflation? First, the overall economy suffers. Specifically, consumers lose purchasing power and their standard of living erodes. Lenders are also hurt as are those who need to borrow. The latter group suffers because lenders raise their interest rates to hedge against inflation. In short, money becomes much more expensive. Finally, import-oriented businesses struggle when inflation is high.
Hyperinflation, on the other hand, hurts almost everyone. It decimates the middle class. It can cause massive bank failures, especially banks with large amounts of outstanding fixed-rate loans. And, although borrowers who have a fixed rate loan do benefit, because prices on everything else are increasing so rapidly, any benefit from the loans is erased by the extreme cost of goods and services. There really are no winners with hyperinflation.
The Potential for Hyperinflation in the U.S. Today
Could the U.S. experience hyperinflation? If you look at the amount of the Feds monetary expansion since 2008, then you would likely conclude yes. For example, when the financial crisis began, the Fed’s balance sheet was around $800 billion. Today, it is over $4 trillion. That’s a tremendous increase. However, it’s important to note that the majority of this new money is sitting at the Federal Reserve and has not actually entered the economy. If this were not the case, if all this capital were allowed to enter the economy, inflation would be very high. Perhaps not hyperinflation, but I believe it would be much higher than it was during the late 1970s.
Why would the Fed flood the market with so much money if it wasn’t intended to enter the economy? Because during the 2008 crisis, not counting the banks that did go out of business, a large number of other banks nearly collapsed. The actions of the Fed were nothing short of brilliant. They created a glut of new money through T.A.R.P., QEII, Operation Twist and QEIII. Then they offered to pay interest to banks on their reserves, which from a financial standpoint made it profitable to banks to leave large amounts on reserve. Hence, with the majority of this new money in reserve, bank balance sheets have been greatly strengthened. It’s important to note that the financial sector must be strong if the economy is to thrive. The Feds challenge will come when it’s time to unwind it all.
With over $4.2 trillion on the Fed’s balance sheet ($3.8 trillion more than at the beginning of the crisis), when demand finally increases and lenders need more capital to lend, or when the Fed decides not to pay interest on bank reserves, the Fed will have to reverse course and, instead of buying bonds (which removes cash from its balance sheet and increases the money supply), it will be selling bonds (removing cash from the economy, reducing the money supply). This is where things could get dicey. This is also why the Fed would like to end QEIII as soon as possible. Because the longer it continues, the more money there will be to remove and this could cause a severe dislocation in the financial markets. In other words, when the Fed ceases QEIII, the stock market could decline along with bond prices.
Is Marc Faber correct in his prediction? Will the U.S. experience hyperinflation within the next 10 years? It all depends on consumer demand and the leadership of the new Fed Chair, Janet Yellen. It will also depend on economic growth in the rest of the world. The road out of the 2008 crisis has been masterfully maneuvered thus far. Will the next leg of the monetary journey be as smooth? I believe the Fed has done an outstanding job, all things considered. However, with a new chairperson, will the Fed continue to guide the economy with the same precision? My guess is that it will. After all, there are a lot of very bright individuals making decisions, and that gives me confidence. We’ll see if Mr. Faber is right. For the sake of all of us, I hope he’s wrong.
Is U.S. Hyperinflation Imminent? - Forbes