How Money Dies-The Process

Telegraph’s Ambrose Evans Pritchard has a nice narrative on hyperinflation.

He writes, (all bold highlights mine)

Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot).

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.

People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

The point is hyperinflation is an outcome of a political process which begins in a nondescript mode or on a benign phase but eventually turns unwieldy.

Murray Rothbard aptly described this process in Mystery of Banking

``When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters a danger zone. The crucial question is how the government and its monetary authorities are going to react to the new situation. When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then clamor for the government to issue more money to catch up to the higher price. If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.”

And as one would observe, the process involves a feedback loop between government actions and market responses or an action-reaction stimulus-response mechanism until everything gets out of hand—and thus, money perishes.

Of course Mr. Pritchard ends up downplaying such risks.

He concludes, ``There is a clear temptation for the West to extricate itself from the errors of the Greenspan asset bubble, the Brown credit bubble, and the EMU sovereign bubble by stealth default through inflation. But that is a danger for later years. First we have the deflation shock of lives. Then -- and only then -- will central banks go to far and risk losing control over their printing experiment as velocity takes off. One problem at a time please.”

He contravenes his earlier anecdote about the benign origins of hyperinflation.

Because inflation is a symptom of the consequences of the actions of policymakers in attempting to attain certain political goals, which as shown above are channelled through the feedback mechanism, this means that if the actions to sustain these political goals would imply the increasing application of inflationism, then the risks of hyperinflation can’t be discounted. The current benign conditions does not signify the remoteness of such risks.

One must put in mind, that what seems to drive the actions of the present batch of policymakers is the seductive appeal of the immediacy of the impact from inflationism, the economic ideological bias and path dependency from recent “successes” of such actions.

Yet Mr. Pritchard can thank his lucky stars that globalization could serve as a counterbalancing force that might be able to reduce (if not delay) the risks of any of the two extreme outcomes of deflation or hyperinflation.