Hyperinflation
In the early 1920s, Ludwig von Mises became a witness to
hyperinflation in Austria and Germany — monetary developments that caused
irreparable and (in the German case) cataclysmic damage to civilization.
Mises's policy advice was instrumental in helping to stop
hyperinflation in Austria in 1922. In his Memoirs, however, he expressed
the view that his instruction — halting the printing press — was heeded too
late:
Austria's currency did not collapse — as did Germany's in
1923. The crack up boom did not occur. Nevertheless, the country had to bear
the destructive consequences of continuing inflation for many years. Its
banking, credit, and insurance systems had suffered wounds that could no
longer heal, and no halt could be put to the consumption of capital.[1]
As Mises noted, hyperinflation in Germany was not stopped
before the complete destruction of the reichsmark. To illustrate the monetary
catastrophe, one may take a look at the exchange rate of the reichsmark
against the US dollar. Before the start of World War I in 1914, around 4.2
marks would buy 1 US dollar. As soon as war action began, the convertibility
of the mark was suspended and paper marks (papiermark) were issued,
largely for financing war-related outlays. In 1918, after the end of World
War I, 8.4marks bought 1 US dollar.[2] In December 1919, the mark had
depreciated to 46.8 per US dollar, and in December 1920 to 73.4 per dollar.
In July 1922, the US dollar cost 670 marks. When French
and Belgian troops occupied the Rhineland at the beginning of 1923, however,
the exchange rate of the mark plummeted to 49,000 marks per US dollar. On
November 15, 1923, when hyperinflation reached its peak, the currency reform
effectively made 1 trillion (1,000,000,000,000) papiermarkequal to 1 rentenmark,
and as 4.2 trillion papiermark exchanged for 1 US dollar at that time, 4.2
rentenmark would equal 1 US dollar.[3]
Increases in the Money Supply
The 20th century saw many hyperinflations, including
China in 1949–50, Brazil in 1989–90, Argentina in the late 1980s and early
1990s, Russia in 1992, Yugoslavia in 1994, and, most recently, Zimbabwe in
2006–09. All of these hyperinflations were the direct result of a system of
unfettered fiat money under government control — a system that produces money
in a non-market-conforming way: the money supply is increased out of thin air
by banks simply extending loans (circulation credit) and/or
monetizing assets.
Hyperinflation is perhaps the darkest side of a
government fiat money regime. Among mainstream economists,
hyperinflation typically denotes a period of exceptionally strong increases
in overall prices of goods and services, thus denoting a period of
exceptionally strong erosions in the exchange value of money. Some people
consider a rise in overall prices of 10 percent per month (which implies an
annual rate of price increases of around 214 percent) as hyperinflation; others
indentify hyperinflation as a monthly price rise of at least 20 percent
(which implies an annual increase in prices of nearly 792 percent).
However, any such numerical definition can be criticized, as it refers to
the symptom rather than the root causeof the accelerating loss of the
purchasing power of money. Economically speaking, hyperinflation is the
inevitable consequence of an ever-greater rise in the amount of money. And
this is exactly what the monetary theory of the Austrian School of economics
teaches: In fact, Austrian theory shows that inflation is the logical
consequence of a rise in the money supply, and that hyperinflation is the
logical outcome of ever-higher growth rates in the money supply.
According to the Austrian school, money is, like any other good, subject
to the irrefutably true law of diminishing marginal utility. It is this law,
which is implied by the axiom of human action, which is at the heart of
Mises's praxeology. As it relates to money, the law of diminishing marginal
utility states that an increase in the quantity of money by an additional
unit will inevitably be ranked lower (that is, valued less) than any
same-sized unit of money already in an individual's possession. This is
because the new money can only be employed as a means for removing a state of
uneasiness that is deemed less urgent than the least-urgent uneasiness which
one has up to now been removing with the money in one's possession.
Money Demand
People hold money because money has purchasing power (which
people desire, given the fact of uncertainty as an undeniable category of
human action), and the purchasing power of money is determined by the supply
of and demand for money.
If a rise in the money supply is accompanied by an equal rise in money
demand, overall prices and the purchasing power of money remain unchanged.
Once people start to exchange their increased money holdings against other
goods, however, prices will start to rise, and the purchasing power of money
will fall. That said, it is rise of the money supply relative to the demand
for money that brings to the fore the obvious effect of an increasing money
supply: rising prices.
Mises saw that money demand plays a crucial role for the possibility of an
unfolding hyperinflation. If the central bank is expected to increase the
money supply in the future, people can be expected to rein in their money
demand in the present — that is, increasingly surrendering money against
vendible items. This would, other things being equal, drive up money prices.
Mises noted that "this goes on until the point is reached beyond which
no further changes in the purchasing power of money are expected."[4] The process of rising prices would
come to a halt once people have fully adjusted for the expected increase in
the money supply.
What happens, however, if people expect that, in the future, the
money-supply growth rate will increase to ever-higher rates? In this case,
the demand for money would, sooner or later, collapse. Such an expectation
would lead (relatively quickly) to a point at which no one would be willing
to hold any money — as people would expect money to lose its purchasing power
altogether. People would start fleeing out of money entirely. This is what
Mises termed a crack-up boom:
If once public opinion is convinced that the increase in the quantity of
money will continue and never come to an end, and that consequently the
prices of all commodities and services will not cease to rise, everybody
becomes eager to buy as much as possible and to restrict his cash holding to
a minimum size. For under these circumstances the regular costs incurred by
holding cash are increased by the losses caused by the progressive fall in
purchasing power. The advantages of holding cash must be paid for by sacrifices
which are deemed unreasonably burdensome. This phenomenon was, in the great
European inflations of the 'twenties, called flight into real goods
(Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse).[5]
The Unrelenting Power to Inflate
If people expect a forthcoming, drastic increase the money supply — but if
they at the same time expect that such an increase will be limited (i.e., a one-off
increase) — the central bank can actually orchestrate a debasing of money
without causing its complete destruction. As long as government and its
central bank succeed in making people believe that any future rise in the
money supply will remain within an acceptable limit, from the viewpoint of
the money holder, monetary policy is an effective and most perfidious
instrument for expropriation and non-market-conforming income redistribution.
This may explain why Murray N. Rothbard, in his famous essay The
Case for a 100 Percent Gold Dollar, wrote the following:
I am not saying that fiat money, once established on the ruins of gold,
cannot then continue indefinitely on its own. Unfortunately … if fiat money
could not continue indefinitely, I would not have to come here to plead for
its abolition.[6]
Rothbard saw the danger that the government-controlled fiat money could be
held up and running indefinitely, that it would not necessarily drive itself
into a fatal and final collapse. As long as people do not expect that a money
supply increase will spin out of control, the central bank is in a position
to debase the currency without completely destroying it.
In other words: hyperinflation would be possible without destroying the
money completely. The crack-up boom, as Mises pointed out, would unfold only
when people come to the conclusion that the central bank will expand the
money supply at ever-greater rates:
But then finally the masses wake up. They become suddenly aware of the
fact that inflation is a deliberate policy and will go on endlessly. A
breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his
money against "real" goods, no matter whether he needs them or not,
no matter how much money he has to pay for them. Within a very short time,
within a few weeks or even days, the things which were used as money are no
longer used as media of exchange. They become scrap paper. Nobody wants to
give away anything against them.[7]
Debt Levels
Today's fiat-money regimes are characterized by ever-greater amounts of
debt relative to real income — caused by policies that try to solve the economic
problems caused by credit and money creation out of thin air by using even
greater amounts of credit and money created out of thin air. And it is fair
to say that the higher an economy's overall debt level is, the more likely
hyperinflation becomes.
To show this, let us assume that after a long period of money creation
through bank circulation credit expansion a credit crisis emerges: Creditors
are no longer willing to roll over maturing debt at prevailing interest
rates. Borrowers cannot repay their obligations when payment is due, and
neither can they afford paying higher borrowing costs. Investors start
fleeing out of bonds, making interest rates increase sharply and thereby
covering up unprofitable investment. More borrowers, including banks, fail to
meet their obligations, and bankruptcies spread. Ensuing recession and rising
unemployment aggravate the collapse of the credit structure.
Should investors in such a situation expect that the government and its
central bank would opt for bailouts financed through additional money
creation, the demand for money and fixed claims would most likely dry up.
This would make it necessary for the central bank to extend ever-greater
amounts of money to struggling borrowers in order to prevent the spread of bankruptcies.
The larger the amount of outstanding debt is, the larger will be the
potential increase in the money supply. The more the money supply grows, the
more likely it is that there will be hyperinflation and a potential breakdown
of money demand: the unfolding of a crack-up boom.
