Monday, October 11, 2010

Economics: Hyperinflation

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If inflation is the creation of new money (which results in higher prices due to the new money devaluing all the other money already in circulation), then what is hyperinflation? Kind of the same thing, but in warp speed and with a couple twists.

Hyperinflation is certainly the rapid rise in the price of consumer goods brought about by overprinting of a fiat currency. However, it not only happens because of the debasing of the currency, but it also happens due to the loss of faith in a currency, so everyone rushes out to spend their money before it's totally worthless, rather than holding dollars people opt for something tangible.

We don't need to look back too far in history to see where hyperinflation has set in and ultimately caused a currency to crash and become utterly void of value. There's so many examples that it's hard to choose, in fact you could probably name the country and they've seen it. Including the United States debasing our own currency during the Revolutionary War. The most recent was Zimbabwe, after a few years of hyperinflation the government abandoned their dollar all together in April of 2009. Inflation ran so rampant that they were printing up denominations in Trillions, can you imagine paying for a Snickers with a trillion dollars?

The hyperinflation in Zimbabwe was the result of massive printing of new money used to pay debts and "buy prosperity". It didn't take long before the market caught on and opted instead to trade in something more valuable like gold and silver. After finally closing shop on the Zimbabwean Dollar their government officially opened itself to foreign currencies to be used. Ultimately these other government run currencies will also eventually disappear, as all government mandated fiat/paper monies do, because the temptation to abuse the printing press is too much for politicians to handle.

I sincerely doubt if our dollar crashes that it will get so bad that we will be digging in the mountains for enough gold to buy bread, but that doesn't mean it will be a cake walk. Hyperinflation is a very real possibility, some are predicting it absolutely will happen, but it's difficult to tell since there are an infinite amount of variables. For instance, China holds the most US debt (coming in 2nd place BTW, is the Federal Reserve), so it's kind of in their interest to not let the US$ fall, or they'll lose money as well, Japan is the 3rd largest holder of our US Treasury Bonds (our debt), as well as many other nations, so if they all decided to sell their debt/Treasury Bonds then it would quickly become worthless and our dollar would entirely crash, so they won't do that, at least not at first.

What if China became convinced that our dollar was going to soon become worthless? They would sell it as quick as they could find a buyer, United States be-damned, because the first to get rid of it ends up hurting the least. As I mentioned last week, the Federal Reserve is getting ready for another round of inflation, who knows if this will trigger the sudden auctioning of our bonds. Another round of inflation will certainly excite our debtors, in a bad way. After all of these bailouts and inflationary practices what we're actually looking at is an enormous US Treasury Bond bubble. EVERYONE is way way way over-invested in US debt. My financial adviser recently showed me a portfolio where 1/3 of the investments were directly in US Treasury Bonds. What happens when the only group of people who will buy those bonds is the Federal Reserve? The bubble pops and we witness the single largest economic collapse in the history of the world.

I know that seems rather hyperbolic, but if you consider the facts then you'll see it's quite easy to justify. 1) The world has never been as connected as it is now, so intertwined that I can invest in China's market place within a matter of minutes. I don't even have to leave my house. 2) Most of the world is tied into our economic system via holding of our debts. Those two things alone set the stage for a systemic collapse, much in the same way that all of wall street saw a systemic collapse of their financial institutions.

The bottom line is that the market is bigger than any government policy or dictatorship. Just ask 1923 Germany, fine, you can't *actually* ask an inanimate object that "lives" in the past, buuut, if you could... Germany's currency was originally backed by gold, which meant you could redeem their goldmark for actual gold, but in 1914 this gold standard was abandoned in order to allow paper inflation to fund the first World War. The war ran longer than anticipated (as it usually does) and since the treaty that cemented their loss of that war demanded reparations they decided to simply print the money, which ultimately caused their hyperinflation and crash of their currency. (It's a bit more complex and interesting, but I'm cutting to the point.)

In fact, war is a common reason why a currency falls, even in our own country we debased the Continental Dollar in order to fund our own revolution. Our founding fathers having seen the destructive nature of paper currency decided to write into the constitution that states could only accept gold and silver for legal tender of debts (Art. 1 Sec. 10) and that only Congress could "coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures" (Art. 1 Sec. 8).

There are no absolutes with regards to ensuring my money today retains at least the same amount of value tomorrow, but there are some pretty good ways to make it difficult to lose its value, and allowing a private entity to print as much as it wants and hand it to whoever it chooses without any oversight whatsoever is probably the worst idea ever, anyone who disagrees is either clinically insane or profiting from it. It's asking the fox to guard the hen house!

Instead of this current monopoly on the dollar that the Federal Reserve has (via mandated US law), perhaps the single best way to ensure that my money retains value is to allow the market to choose. Competition is good, because everyone votes with their money, and if I think someone is ruining a currency then I can choose to use another and be exempt from its downfall. That very concept, that I can choose someone else's currency will drive honesty into business, or that business will be driven out of town. But as of right now, if hyperinflation sets in and we see prices double over the course of a couple weeks, there is no reprieve for US Citizens who don't have the capital to buy valuable assets and commodities like gold and silver, instead we'll see the savings of responsible people fall into nothingness overnight and only be left with political grandstanding by the ones who allowed this to happen in the first place.

While hyperinflation and the destruction of the dollar remains a very real possibility, I would say the biggest and first indicator is likely going to be when oil stops trading exclusively in the dollar. Until then just plan your finances wisely and tie your savings to something that retains its value, I think that there is NO reason to have more than a couple thousand sitting in cash in a bank account.

So, if inflation & hyperinflation is when a currency loses its value, what happens if a currency *gains* in value? Deflation, and it's a good thing.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

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