- The risk of an outbreak of high inflation in the United States is rising. We are approaching a critical point where the ability of the US economy to grow while the monetary base is reduced will be tested. If the US economy falters, or if the Fed blinks and fails to reduce the monetary base, then the value of the US Dollar, a proportional claim on the future output of the US economy, could fall sharply and prices could rise significantly.
- The market value of money is the denominator of every money price in the economy. The view of The Money Enigma is that the market value of money depends primarily upon the expected long-term growth of real output relative to the expected long-term growth of the monetary base.
- Presently, the market expects strong real output growth and a reduction in the monetary base. If these expectations are disappointed, then the market value of money could drop precipitously, triggering a period of high inflation.
- Ultimately, the prospects for hyperinflation depend upon the “real health” of the US economy. If the US economy is an innovation machine that grows solidly as the monetary base is reduced, the value of money will be protected. But if the US economy is merely a house of cards supported by cheap debt, then hyperinflation is a real possibility.
Introduction: the rIsk of hyperinflation in the US
The value of the fiat money that we use in our everyday transactions depends on market confidence in the long-term economic prospects of our society. If confidence in the long-term future of a society is strong, then fiat money will generally hold its value well and inflation will remain contained. However, if confidence is suddenly lost, the value of fiat money can quickly collapse leading to what is known as “hyperinflation”.
While the risk of hyperinflation in the United States in the next five years may be small, the risk is rising. A collapse in the value of the major fiat currencies may seem unimaginable to most people, but the risk is material. The key to appreciating this risk is examining how money prices are determined and, just as importantly, understanding how money derives its value.
There are many who will scoff at the notion that the United States could ever experience hyperinflation. The recent run of weak US inflation data, the deflationary experience of Japan and the strength of the US Dollar have combined to create a false sense of security on this issue.
Hyperinflation in the United States may be a “black swan” event, but as discussed by Nassim Taleb and others, “black swan” events seem to be occurring more frequently than predicted by statistical models.
Most people tend to treat “risk” in a binary fashion. Either its significant enough that we need to care, or it is low enough that we just ignore it. Six years ago, the risk of hyperinflation in the United States was definitely in that first camp. But times have changed. This week we will discuss how a number of key economic factors are coming together to create a possible tipping point, a point at which inflation begins to accelerate and becomes very hard to control.
The key point that we will discuss this week is that the price level today depends almost entirely upon expectations of the long-term path of the “base money/real output” ratio.
Right now, the markets are very optimistic in this regard. Most people believe that, over the next 20-30 years, real output in the US will continue to grow at solid rates (2%-3% per year), while the monetary base will decline as the Fed gradually reverses QE before resuming its long-run trend growth (about 6% per year).
However, if these expectations shift even slightly, the value of the US Dollar could fall significantly and the price level could rise dramatically.
For example, if markets begin to appreciate that the historic growth rates of the US over the past 20 years simply can not be achieved over the next 20 years, then this will have a negative impact on the value of the US Dollar and a positive impact on prices (inflation will rise). Moreover, if markets realize that the US economy has become addicted to monetary stimulus and “can’t get off the drug”, then expectations for the long-term path of the monetary base will be revised up leading to what could be the most severe inflationary outbreak in modern US history.
Ultimately, determining the risk of hyperinflation in the United States comes down to a call on the “real health” of the US economy. Is the US economy an innovation machine that will grow solidly as the monetary base is reduced? Or is the US economy merely a house of cards supported by cheap debt?
While readers may be divided on the real health of the US economy, this week we shall explore why the real health of the US economy is the key issue in determining the risk of hyperinflation. More specifically, we shall explore why the price level is so dependent upon expectations of both the long-term future path of the monetary base and real output.
In order to understand this theory, we need to go back to first principles and begin with a simple question, namely “how are prices determined?”
What determines a “money price”?
The view of The Enigma Series is that every price is a relative expression of the market value of the two economic goods being exchanged. The price a good, in money terms, depends upon both the market value of the good and the market value of money. The market value of money is the denominator of every “money price” in the economy. As the market value of money falls, the “money price” of a good, all else equal, will rise.
Every economic transaction involves, at a minimum, an exchange of two items. The “price” of the transaction is simply the ratio of the quantities of the two items exchanged. For example, if the price of bananas is $3, then this means that you must exchange three dollars for one banana.
This ratio of exchange is determined by the relative market value of the two items being exchanged. In our scenario above, one banana is three times more valuable (in a market value sense) than one dollar. Therefore, in order for you to purchase one banana, you must offer three dollars for it.
In order for one good to have a price in terms of another good, both goods must possess the property of “market value”. For example, why does coffee have a price but sunshine does not? Most people would simply say that sunshine is “free”. But at a more fundamental level, the reason there is a price for coffee and not a price for sunshine is that coffee possesses the property of “market value”, whereas sunshine does not possess the property of “market value”.
For a good to have a price, it must possess the property of “market value”. Frankly, this is rather obvious observation. However, what the more important observation we need to make is that for a good to measure the market value of another good, that first good must itself possess the property of market value.
Let’s put that in terms that most are more familiar with.
In order for money to measure the market value of other goods (in order for “money prices” to exist in our economy), money must possess the property of market value. Furthermore, the “money price” of a good reflects the relative market value of the good in question (the “primary good”) and the market value of money (the “measurement good”).
Let’s think about this in abstract terms for a moment. Why can’t we express the price of all things in “sunshine terms”?
The reason we can’t measure the market value of all goods in sunshine terms is because sunshine does not possess the property of market value. We can’t measure the market value of bananas in sunshine terms because only one of the goods in the exchange (bananas) possesses the property of market value.
The reason we can express the price of goods in terms of money is because money possesses the property of market value. In any simple two-good exchange, the price of the transaction depends upon the market value of the “primary good” and the market value of the “measurement good”. If one unit of the “primary good” (for example, one banana) is three times as valuable as one unit of the “measurement good” (for example, one dollar), then the price of the primary good, in measurement good terms, is three units of the measurement good per one unit of the primary good (or, in the case of our example, three dollars per banana).
If the “measurement good” does not possess the property of market value, then we can’t express prices in terms of that good. We can only use money as a “measurement good” for our prices because it possesses the property of market value. Clearly, we can’t use sunshine as our measurement good (we can’t express prices in sunshine terms), because sunshine doesn’t possess market value.
So, let’s return to the main issue. What determines the price of one good, the “primary good”, in terms of another good, the “measurement good”? Is the price determined by the market value of the primary good, or is the price determined by the market value of the measurement good?
The answer is “both”.
In a barter economy, the price of bananas, in apple terms, depends upon both the market value of bananas and the market value of apples. The price of bananas, in apple terms will rise if the market value of bananas rises. More importantly, the price of bananas, in apple terms, will rise if the market value of apples falls.
Similarly, the price of bananas, in money terms, will rise if the market value of bananas rises or if the market value of money falls. If the market value of money falls, then bananas are relatively more valuable, even if they are not absolutely more valuable. Price is a relative expression of two market values. Hence, the price of bananas, in money terms, will rise if the market value of money falls (all else remaining equal).
Some readers may ask how this view of price determination reconciles with traditional “supply and demand” theory. The view of The Enigma Series is that every price is a function of two sets of supply and demand. Those interested in this idea should read a recent and very popular post titled “Every Price is a Function of Two Sets of Supply and Demand”.
We can extend this microeconomic concept of price determination to a macroeconomic discussion of inflation. In simple terms, rising prices across the economy can be caused either by (1) an increase in the market value of goods and services, or (2) a decrease in the market value of money.
The market value of money is the denominator of every “money price” in the economy. As the market value of money falls, all else remaining equal, money prices will rise.
The Ratio Theory of the Price Level, presented in the slide below, encapsulates this simple notion.
The key to the Ratio Theory, as with many of the theories discussed in The Enigma Series, is recognizing that the property of market value can be measured, at least theoretically, in absolute terms, that is to say, in terms of an invariable measure of market value. In the slide above, the market value of goods VG and the market value of money VM are both measured in terms of a theoretical and invariable measure of market value called “units of economic value”. Those readers who are interested in exploring the measurement of market value in both absolute and relative terms should read The Inflation Enigma.
Let’s return to the key point of discussion: hyperinflation.
The key takeaway from our discussion so far is that every “money price” in the economy depends critically upon the market value of money. Once this principle is appreciated, the key to understanding hyperinflation is an examination of what determines the market value of money, the denominator of the price level.
What determines the “market value of money”?
From a high-level perspective, the view of The Money Enigma is that the market value of a fiat currency depends upon expectations of the long-term economic prospects of the society that has issued that currency.
For example, the purchasing power of the US Dollar at any point in time depends critically upon market confidence in the future economic growth of the United States and the market’s trust that policy makers will manage the government’s balance sheet (government debt and the monetary base) in a prudent manner.
Hyperinflation develops when the market rapidly loses confidence in the long-term economic prospects of a society. Zimbabwe is a great case in point. Once the market begins to realize that underlying economic growth is poor (or worse, a country is going backward) and that the government needs to print more and more money just for the country to standstill from an economic perspective, the value of that currency begins to decline rapidly.
But why is this case? Why is the value of money so sensitive market confidence in the long-term economic prospects of a society?
The reason is that money is a long-duration, special-form equity instrument of society. More specifically, each unit of the monetary base represents a proportional claim on the future economic output of society.
We have discussed this basic thesis in a few posts recently, most notably “Money as the Equity of Society”.
While we will not go into all aspects of the argument in this post, the thesis of The Money Enigma is that money derives its value “contractually”. More specifically, there is an implied-in-fact contractual agreement between society (the issuer of money) and those that hold money (“moneyholders”) that the monetary base represents a claim to the future output of society. Moreover, money represents a proportional (as opposed to fixed) claim that future output.
In this sense, money is very similar to a share of common stock.
Each unit of the monetary base represents a proportional claim on the future output of society, just as a share of common stock represents a proportional claim on the future cash flows of a corporation. As the expected future cash flows of a business rise, the share price becomes more valuable. As the expected future shares outstanding rise, the share price becomes less valuable.
Similarly, the value of money depends upon expected future output and the expected future size of the monetary base. As the expected future output of a society rises, the value of a proportional claim to that output (the value of money) will rise. Alternatively, as the expected future monetary base outstanding rises, there are more claims to any given future output and, therefore, the current value of each proportional claim to that output (the current value of money) will fall.
Those readers who are math geeks might be interested in the slide below that illustrates the valuation model for money that is developed in the final paper in The Enigma Series, “The Velocity Enigma”.
In essence, this valuation model is very similar to a valuation model for a share of common stock. The value of money rises as expectations regarding long-term real output growth strengthen (“g” rises). Conversely, the value of money falls if people decide that the monetary base will grow at a faster rate than previously expected (“m” rises).
Could hyperinflation happen in the United States?
Let’s bring the discussion back to the question at hand. Could the value of the US Dollar collapse dramatically at some point over the next 5-10 years?
Many commentators seem to believe that if the US Dollar hasn’t collapsed in value by now, after seven years in which the monetary base has more than quadrupled in size, then it will never happen. This perspective displays a stunning ignorance of the role that long-term expectations play in the determination of the value of money.
The value of money depends upon expectations of the long-term (20-30 year) path of the ratio of “real output/base money”. Although the recent QE program has quadrupled the monetary base, most market participants consider the program to be temporary. Moreover, over the past few years, confidence in the long-term prospects for real output growth in the United States have improved.
Both of these factors have supported the current value of the US Dollar, a long-duration, proportional claim on the output of the United States.
This experience is relatively typical of any country when it first experiments with money printing. Money printing boosts the economy and leads to upward revisions in expectations for long-term growth, a factor that supports the value of money and suppresses the price level. Moreover, the money printing is normally sold as a “temporary” measure: something that will be reversed once the economy is strong enough to support it.
“Temporary” increases in the monetary base should have little or no impact on the predicted path of the long-term monetary base and therefore should have no impact on the value of money and the price level.
In theory, the Fed could increase the monetary base by as little or as much as it likes without impacting the value of the US Dollar, provided that the increase is considered to be “temporary” in nature. Moreover, if the Fed’s actions boost confidence in long-term economic growth, then printing money could lead to a rise in the value of money and deflation!
But there is a catch. Sooner or later (and generally sooner), the “temporary” increase in the monetary base needs to be reversed. And this leads us to the interesting position in which we find ourselves today.
Current market expectations reflect what I regard as an extreme level of optimism regarding the ability of the US economy to grow as the Federal Reserve normalizes (shrinks) the monetary base.
In order for the Federal Reserve to normalize the monetary base, it must sell at least $2 trillion worth of US government fixed income securities. The inevitable impact of this will be higher long-term interest rates and “volatility” in investment markets.
Why is the problematic? Well, the bear case, which I support, is that debt levels in the US are too high and can only be supported by the current regime of low interest rates. To be fair, this is not just a US problem. Over the last thirty years, the entire Western World has taken on enormous private debts. The financial crisis in 2008 saw a brief private sector deleveraging, which has subsequently been reversed, but government debts have risen dramatically in the last 7-8 years.
Can the Federal Reserve reduce the monetary base without leading to a significant and sustained private sector deleveraging and a massive fall in economic output? If it can, then the value of the US Dollar should be preserved and inflation will remain a “non-issue”. However, if it can’t, then at some point markets will realize that the long-term path of the monetary base relative to real output is much higher than expected, leading to a significant decline in the value of money. If that decline in the value of money is significant enough, then the result will be hyperinflation.
Ultimately, this is a call about the “real health” of the US economy. Is the US economy an innovation machine that will grow solidly as the monetary base is reduced? Or is the US economy merely a house of cards supported by cheap debt?
If the first case is right, then inflation should remain contained. But if the bears are right, then hyperinflation is a very real possibility.