Hyperinflation

Why "printing money" isn't the only cause of hyperinflation.

Modelers in the US have long ignored changes in the rate of inflation, assuming something in the 2% range that aligns with Federal Reserve Bank goals and then assume it does not vary from there. Those in post WW1 Weimar Germany, Zimbabwe in the decade following 2000, and others have experienced levels of inflation that show us hyperinflation is not just theoretical. Features often include a collapse of production and debt denominated in foreign currencies. The government becomes illegitimate and can’t collect taxes. Could it happen in the United States? Should risk managers develop a game plan?

At its core, inflation is based on trust and plays out through actions, mainly printing money under a fiscal dominance scenario where the central bank is the primary buyer of government debt. There are two extremes. If I don’t trust the economy and think prices will fall, I hoard currency and the turnover, or velocity, of money is low. This leads to a stagnant economy and is deflationary. If I don’t trust the system and expect prices to rise, then I prefer purchases to holding currency.

The United States is cushioned in hyperinflation scenarios by its reserve currency status. The dollar backs much of the global economy and many currencies are pegged to it. However, this is a privilege. Punishment to the Russians following their Ukraine invasion included making it harder for them to participate in trades involving the dollar. Now countries know that the US treats the reserve currency as a political asset, so some are letting their US Treasuries mature without rolling them over and buying gold instead. Some trading blocs use the Chinese Yuan, but this volume is still small for now.

In my lifetime, the only burst of inflation in the US was due to the oil supply shock of the 1970s, where inflation spiked but did not reach 14%. As we prepare to celebrate 250 years of independence, only Revolutionary War money printing in 1778 (it’s not worth a Continental) and briefly during the brief post-World War 1/influenza depression of 1920 saw inflation reach 20%. It doesn’t happen often, and recency bias encourages us to think it can’t happen in the future. In 2022, inflation peaked at just over 9% due to Keynesian stimulus delivered directly to consumers but did not persist at that level once the direct payments stopped.

Deficits have been consistent and growing since the small surpluses run during the Clinton era and the debt-to-GDP ratio continues to rise, now above 100% even when ignoring off-balance sheet commitments and above 120% when they are included. The Federal Open Market Committee set a 2% inflation target in 2012 and allowed additional flexibility in 2020 during the COVID crisis. It has been above its goal recently but still is nowhere near the 50% MONTHLY rate necessary to be officially considered hyperinflation.

Fiscal budgets for countries often grow to high levels during a war or financial crisis and it is recognized that these deficits need to be reversed in the years following. People understand that and, while not happy to have to tighten their collective belts they begrudgingly do so. Voters hold politicians accountable and central banks tighten monetary policy. This contracts the economy but can be offset by soldiers returning home eager to work, spend and start a family.

The content of this newsletter is meant to be educational and thought provoking. Nothing in it should be interpreted as investment advice.

Modern Monetary Theory (MMT) assumes that a country with the reserve currency can run deficits without risk of inflation, but this assumes revenues eventually balance spending. The high levels of debt in the US, combined with the challenges being made to the dollar, mean that the United States and other developed countries are not as resilient as they had been and the risk of hyperinflation should not be ignored.

Let’s consider some historical events and their causes. The most studied period of hyperinflation is 1920s Germany, forced to print money and run deficits to pay for overbearing WW1 reparations. Workers were paid in cash and immediately visited markets before the currency’s value became misaligned with prices. This period laid the groundwork for a global depression, the rise of the National Socialist Party, and World War 2. Economic conditions interact with political outcomes. Greece experienced hyperinflation near the end of WW2 and Hungary experienced a period where prices doubled every 15 hours immediately following the same conflict.

Events in individual countries can also lead to hyperinflation, with examples occurring in 1920s Russia (7 years, longest continuous period in history, following the Bolshevik Revolution), 1990s Russia (breakup of the Soviet Union with price controls lifted), Yugoslavia in 1992 (war), Zaire in the early 1990s (runaway deficits), Zimbabwe in 2008 (printing press) and Venezuela in 2017 (poor economic policies).

Currency stabilization can incorporate conservative fiscal and monetary reforms that restore trust in the currency. New currencies were backed by land in the Weimar Republic of Germany, but typically a combination of gold and foreign currencies is used. Central banks are created or become independent, fiscal austerity is introduced to eliminate deficits, regulations are tightened, and the currency is devalued or tied directly or indirectly to a foreign currency.

Policies that have been tried unsuccessfully include confiscating bank accounts and price controls. They lose trust with their citizens while also slowing the economy, encourage under the table black markets and result in shortages. Successful policies are implemented quickly and there is often a change in leadership at the same time to make the changes more credible.

Inflationary expectations drive results as if self-fulfilling. If high inflation is anticipated, workers will demand offsetting wage increases. Multi-year negotiated contracts can make it hard to tame inflation. Prices and wages participate in a cycle where each drives the other higher. A previously ineffective monetary policy must earn back the trust of the population to be effective, although a recession can also dampen prices. Payments and wages may include a cost-of-living adjustment, or COLA. These automatic adjustments make it hard to fully eradicate inflation. Sometimes you will see shrink-flation, where sizes get smaller, or non-wage benefits added rather than salary. During WW2 this is how group health insurance was first offered. Wage increases were capped so alternative benefits were developed and offered to employees to retain them.

Risk managers should develop scenarios that consider double digit inflation quantitatively, and both stagflation and hyperinflation qualitatively. For many firms these extreme scenarios result in bankruptcy as hedges are ineffective when tight monetary policy takes effect. While lagging indicators like the velocity of money are useful, risk managers should be proactive by scanning for leading indicators of high inflation like the M2 money supply metric or the price of gold and other commodities, watching the supply chain and thinking about extreme events.