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Inflation? What Inflation?


Inflation is when prices rise, we all know this from listening to our grandparent prattle on how a nickel would buy a pair of shoes, lunch and a street car ride in “their day”.  On the other hand Hyperinflation is extreme inflation that happens when an economy collapses. Hyperinflation arises only under the most extreme conditions, such as war, political mismanagement, or the transition from a command economy to a market-based economy. If you compare the U.S. to countries that have experienced hyperinflation — think Iran, North Korea, Zimbabwe, and the former Yugoslavia, for example — the U.S. doesn't even come close. Hyperinflation begins when a country experiences an inflation rate of greater than 50 percent per month — which comes out to about 13,000 percent per year. Although it experienced elevated inflation around the time of the Revolution and the Civil War, the United States has never passed this magic mark of true Hyperinflation.

After World War One Germany was required to pay back the cost of the war. They could only do this by printing Marks. In 1922, the highest denomination was 50,000 Mark. By 1923, the highest denomination was 100,000,000,000,000 Mark. In December 1923 the exchange rate was 4,200,000,000,000 Marks to 1 US dollar. In 1923, the rate of inflation hit 3.25 × 106 percent per month (prices double every two days). Beginning on 20 November 1923, 1,000,000,000,000 old Marks were exchanged for 1 Rentenmark so that 4.2 Rentenmarks were worth 1 US dollar, exactly the same rate the Mark had in 1914. As the picture shows in 1922 it was cheaper to burn money than to buy wood. Many historians feel that Adolf Hitler’s rise to power was a result of the destruction of the German Mark.

Periods of moderate inflation can be good for an economy; Japan is right now trying to create some inflation. Inflation is not easy for people to perceive. For example real estate purchased in the 1980s for $130,000 that inflates to $400,000 by 2007 appears to be a wise investment, until you do the math and find the return on investment is only 4.5%. After inflation for that period, the real return was less than 1.5%. Still if you don't do that math (and most don't)  it creates a kind of wealth effect in people’s mind and that is good for the economy.

People really only spend money when they feel they can afford something or when they invest to make more money. Both happen more frequently during mild inflation. Moderate inflation leads to strong housing markets, rising stock markets, investment and growth. The real losers in an inflationary era are people on a fixed income most notably the elderly on pensions.

From a simplistic standpoint inflation is a result of too much money printing flooding the market. That is what happened in Germany in the 1920’s and the United States in the 1970’s. Many alarmists feel that the current fed stimulus is a kind of money printing and that the results will be hyperinflation. It was this crowd that created speculative Gold Bubble. See my article After the Gold Rush.

But what quantitative easing really did was increase the US national debt, give the funds to the banks at near zero interest, the banks bought US Treasury Bonds at 2% return and used the assets and profits of these “risk free” trades to bolster the bank’s balance sheets.

Because the 2007-09 recession hit the financial sector especially hard, banks are holding back on lending as they rebuild their capital. Many consumers are over-indebted and are trying to pay down their balances instead of borrowing more. In some cases, their credit lines are being cut or they are having a hard time getting additional credit. Depressed housing prices have not only slowed the turnover of real estate, but have also removed one of the cheapest ways of borrowing – home-equity loans. Finally, although companies are piling up huge amounts of cash, they have no reason to spend aggressively on expansion and new ventures when consumer demand is depressed and the financial and political outlook remains so uncertain.

What many people fail to understand is that the money created by the Fed, through programs like Quantitative Easing, is what’s known as “state money” (monetary base). In the U.S., this makes up only 15 percent of the money supply, broadly measured. The remainder is made up of “bank money” — the all-important portion of the money supply produced by banks through deposit creation.


So, while the Fed has more than tripled the supply of state money since the collapse of Lehman Brothers in September 2008, this component of the money supply is still paltry compared to the total money supply. In fact, when measured broadly, using a Divisia M4 metric, the U.S. money supply is actually 6 percent below trend

There are a number of factors that affect the growth of money, but there are two main factors that have hampered broad money growth in the United States since the financial crisis. They are both government created. The first is the squeeze that has been put on the banks, as a result of Dodd-Frank and Basel III capital-asset ratio hikes. By requiring banks to hold more capital per dollar of assets (read: loans), the regulators have put a constraint on bank’s balance sheets, which limits their ability to lend. In consequence, money supply growth has been slower than it would have otherwise been.

More stimulus, by itself, won't be able to get the economy moving again. The government can run a huge deficit, the Fed can hold interest rates down, and Fed Chairman Ben Bernanke can pump money into the system with a third round of quantitative easing, but that won't necessarily make the economy speed up – at least not right away. On the other hand, the fiscal cliff, with its spending cuts and tax increases, could depress the economy further.

Click here to hear it Bens own words (caution: this is really boring)

The United States has been moving up the value add chain. Today the US is manufacturing more advanced and profitable products, adding value with innovation and technology. They also are losing many low-end manufacturing jobs and that creates high unemployment.  So long as unemployment remains and banks do not over lend the odds of hyperinflation are remote.

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