How Likely Is Hyperinflation in the United States?

“In discussing this question, let me state two facts which in my view cannot be denied: First, that the present crisis has been initiated by the Federal Reserve’s too expansionary monetary policies after the (2001) bursting of the New Economy bubble. Second, that the Fed and the US government embarked on even more expansionary policies to fight the current crisis: indeed, their policies constitute an experiment on a scale that has never been seen before in the history of fighting crises.”

Peter Bernholz December 15, 2009

Peter Bernholz has earned our most careful consideration on this matter.  He is the world’s leading expert on hyperinflation, a professor emeritus at Basel University in Switzerland, and a member of the Academic Advisory Board of the German Minister of Economics. He is also a former President of the European Public Choice Society, who has deep insights into the working of political markets.

In his famous book, Monetary Regimes and Inflation: History, Economic and Political Relationships,  Bernholz demonstrated that hyperinflations resulted whenever 40 per cent or more of government expenditures were financed by money creation (resort to the printing press). In 2009, approximately 42 per cent of US government expenditures were financed by some form of credit.  So the prospect of hyperinflation, however remote that may appear to be at the present time, cannot be ignored.

Bernholz presents the relevant facts: The monetary base of the Fed grew by about 99 per cent over the 12 month period August 2008 to July 2009.  The US deficit increased from 2.9 per cent of gross domestic product in 2007 to 8.0 per cent in the fourth quarter of 2008; for 2009, a deficit of 10.2 per cent is anticipated, implying that the  US national debt will reach 73.2 per cent of gross domestic product in 2009, and inevitably will continue to rise into the foreseeable future.

At the present time, there is little sign of significant inflation.  In my judgment, that is because the monetary multiplier is suppressed because of the toxic assets that continue to contaminate the balance sheets of  US  banks.  The banks simply will not extend loans in multiples of  expanded base money.  However, the fact that they will not lend does not imply that the demand for loanable funds has diminished. Evidence is quite the contrary.  The US economy is not inflicted by a Keynesian liquidity trap.

So what happens once the financial sector restructures its financial ratios to regain levels that were abandoned during the bubble economy of the mid-noughties. What happens when the money multiplier kicks in, economic recovery is under way, and the massive increase in Fed base money offers the opportunity for  significant inflation?  Can and will the monetary authorities reduce the swollen monetary base, can they do so in time, and will they do so?  These are different questions, seemingly with different answers that should be explored.

From his detailed discussions with board members of several central banks (including the Fed) Bernholz is moderately convinced that the central banks technically are able to reduce the monetary base and to increase interest rates to their natural levels of between 3 and 4 per cent  at any time. Economic adjustment will not be instantaneous, because of  lengthy lags in the impact of monetary policy change, but it will eventually occur. The problem lies in the political implications of such a major monetary contraction, the recessionary and budgetary  implications of tightening the monetary corset. 

The Fed has been politicized by Ben Bernanke and his Board following the financial crisis of September 2008. Congress and the President are now looking over his shoulder all the time. Both the Democrat-majority in Congress and the President are aware of what happened in 1994 when policy mis-judgments by President Clinton (and his wife) resulted in the resurgence of the Republican Party and the abortion of Clinton’s domestic policy agenda. They understand that the 2010 and 2012 elections are critical for any continuation of the progressive liberal policy agenda in the United States. They do not relish having another Newt Gingrich throttling the presidential throat.

So, if the Fed is not allowed to reduce the monetary base at a rate designed to abort inflationary pressures, inflation most surely will follow, with all the harmful consequences that US citizens have learned from experience during the Carter presidency. But will inflation spiral into the kind of  hyperinflation that destroys civil society, that leads to the displacement of fragile democracies with various kinds of dictatorship?  

Bernholz, thankfully, is optimistic on this issue.  Although his research clearly indicates that government expenditures financed more than 40 per cent  by credits historically have led to hyperinflation, the composition as well as the size of the credits turns out to be important. The 12 major hyperinflations that he has evaluated  were caused  in each instance by the financing of huge budget deficits through money creation. The story does not hold for borrowings taken up in the capital markets if they are not resold to the central bank.  According to Bernholz’s calculations, not 42 per cent, but only 13 per cent of US government expenditures currently are financed by money creation.  For this reason, there is presently no danger of hyperinflation in the United States, although, in Bernholz’s judgment, inflation may well rise, more or less strongly, during the next few years.

Let us be truly thankful for large mercies!

 

Tags: budget deficits, credit creation, hyperinflation, money expansion, policy lags, politicization of the Fed