Part 10: When Money Dies
by Gary North
by Gary North
Recently by Gary North: When Frankie Met Johnny: The 1934 Meeting of Roosevelt and Keynes
Bottom line: "When money dies, so do people." Hyperinflation in a modern urban nation would kill people. I think it would kill a lot of people.
Why? Because we rely on the social division of labor to feed ourselves, heat our homes, and supply everything else that we buy or sell. This requires a highly complex price system. At the heart of this system is money. It would not exist without money.
The free market coordinates the buying selling of billions of products and services. Products are tracked by an identifier called a stock keeping unit, or SKU. In the region around New York City, there are something in the range of ten billion SKUs, according to economist Eric Beinhocker (The Origin of Wealth, 2007, p. 9). This does not count services. The service sector is more than twice the size of the goods sector in the United States.
We give little thought to the intricate process that delivers the goods we want to buy at the place where we shop and at the time when we show up to buy. No system of central planning is capable of coordinating supply and demand on the scale of a modern economy. This was the heart of Ludwig von Mises' critique of socialism in 1920. His short article, "Economic Calculation in the Socialist Commonwealth," made the economic theoretical case against socialism by arguing that without free markets, and especially capital markets, no central planning agency can know what anything will cost in terms of forfeited opportunities. You can read the article here.
One implication of this article is that hyperinflation would collapse the division of labor. Without reliable, predictable pricing, most people would make errors most of the time in estimating what things should cost. This is as true of our decisions as producers as consumers.
Money allows us to make bids in the market for the ownership or use of scarce resources. These bids are our responses as both consumers of goods and suppliers of goods. If prices no longer convey predictable information over time, planning becomes chaotic. Producers and consumers will erroneously forecast the state of supply and demand. Our errors add up over time. We produce losses. We find that we have consumed our capital. We cannot replace what we have consumed at prices we thought would prevail.
Money is our means of assessing what it costs to pursue our goals. The less reliable the information conveyed by prices, the less efficiently we can attain our goals. Our goals shift as we find ourselves facing supply and demand conditions that we did not foresee.
No one likes to make mistakes. Mistakes are expensive. They force us to consume our reserves or else do without. Mistakes thwart our plans.
Monetary inflation distorts information regarding the supply and demand of capital. It does so by lowering interest rates. Because there is more money available for entrepreneurs to borrow, lenders are forced to lower their price: interest to be repaid. The market clears the supply and demand for capital through changing prices. This is true of all other markets.
Monetary inflation either raises prices or else keeps prices from falling. This imposes losses on people who expected prices either to remain stable or else fall. Misleading price signals are a form of deception.
Civil governments approve of the short-term effects of this deception. Unemployment falls. People are hired to engage in new product creation. Demand for idle resources increases. The voters like the results, and they reward incumbent politicians by re-electing them.
But there are no free lunches in life. There is also no free information. The cost of obtaining accurate information rises, because the supply of misleading information has increased. The central bank increases the monetary base when it purchases assets with newly created money. The commercial banks extend this newly created money by making loans. The original misinformation multiplies. It spreads throughout the economy. The production of misinformation is the heart of fractional reserve banking process.
SUSTAINING THE BOOM
The true conditions of the supply and demand of capital are revealed subsequently through competitive bidding by consumers. The consumers never decided to save more money at the pre-inflation interest rates. Now their bidding with newly created fiat money reveals that projects that had been launched on the basis of one set of price signals — lower prices — had been incorrect. The projects are abandoned. Think "shopping malls." Think "tracts of new homes." Consumers prefer to buy other things. Their budgets are squeezed by rising prices. They reallocate their spending. The companies they cut off go bankrupt.
Unemployment rises. The supply of unsalable products and services is greater than demand at yesterday's prices. So, producers cut prices. This reveals to them and to their accountants that their plans had been error-filled. Losses increase.
This is bad for incumbent politicians, who had taken credit publicly for the booming economy. They are then susceptible to special-interest groups that plead for government handouts. The banks — lenders of first resort — cry for aid from the Treasury and the central bank. The central bank becomes the lender of last resort to the Treasury, and the Treasury extends loans to struggling banks, or even buys shares of these banks.
This moves the economy closer to the centrally planned economy that Mises warned could not work because it cannot assess the true conditions of supply and demand. Errors increase. This brings forth new cries from special interests for additional subsidies by the government.
If the central bank responds by purchasing more government debt, and if commercial banks lend this newly created fiat money, the money supply rises, prices rise, and a new wave of misinformation spreads through the economy. Producers and consumers make even more mistakes. When the central bank seeks to sustain the boom by pushing down interest rates through an increase of asset purchases, it moves into a mass inflation scenario: double-digit increases in the money supply, which is followed by rising prices. Only if commercial banks refuse to lend the money that they are legally entitled to lend, preferring instead to keep this money as excess reserves at the central bank, does the central bank's actions not increase the money supply. In such a situation, the recipient of the central bank's newly created money — the national government — increases its share in the economy. The percentage of the economy that is dependent on government planning and spending increases. So, the economy moves closer to the irrational decision-making described by Mises in 1920.
THE STAGES OF DISINTEGRATION
The first stage is the initial boom created by the central bank's increase in the money supply. This is offset by the subsequent recession, when property owners and money holders re-price their assets downward.
The second stage is the infusion of more fiat money by the central bank. This is done in an attempt to offset the recession, which is the outcome of individuals' decisions to re-price their assets and adjust their budgets accordingly.
This second stage fails unless the public is misled sufficiently to re-price their assets and readjust their budgeting once again. But this re-pricing and budget readjustment are based on false information. The spread of misinformation increases, along with the fiat money.
When the deception is again discovered, the recession reappears. But the misallocation of capital is even worse at this stage than it was in the first stage. The deception has gone on longer.
So, the central bank must intervene again. And again. Prices increase. The government's official price index rises. This is a threat to incumbent politicians.
The politicians want the central bank to intervene again. If it does, the economy will move to double-digit price inflation, the way it did in the United States in 1979 and 1980.
The central bankers must then decide whether to continue to increase the monetary base. If they do, the economy moves to mass inflation, which I define as consumer price increases above 20% but below 50%.
This is not hyperinflation. Stage three is hyperinflation, where prices rise above 50% per annum. Stage three is characterized by a flight out of money into commodities, foreign currencies, and precious metals. Because the precious metals are thin markets, their rise vastly exceeds the consumer price index or commodities in general. Only if central banks, as an international guild, sell gold into the private markets, never to return, can this outcome be postponed.
STAGE TWO POINT FIVE: PRICE CONTROLS
In between mass inflation and hyperinflation, the government may declare price ceilings. In this case, the central bank continues to buy government debt, the government continues to spend it, and recipients deposit the money in their banks. If bankers continue to lend, the money supply increases.
With rising prices in the free market — now identified as black markets — and laws against selling at market-bid prices, goods and services become more scarce. That is, at an artificially low price, there is greater demand than supply. The availability of goods erodes away.
The United States experienced this from 1942 to 1946. The government created ration cards: non-monetary tickets that supposedly allowed holders to buy a specific quantity of goods. Result: quality went down on the legal markets.
This system was described best by a Russian workers' slogan in the Soviet era: "The bosses pretend to pay us, and we pretend to work."
The result is reduced wealth for participants in the legal markets, increased risk for participants in the black markets, and politicians who blame black marketeers for the shortages.
There are two ways out of this stage: (1) the stabilization of money, the fall in prices, and the abolition of controls; (2) the abolition of controls and an increase in the money supply.
Let us consider the first alternative. If the controls had produced shortages on a massive scale, as they did from 1942 to 1946 in the United States, the removal of controls, coupled with stable money or even monetary deflation, does not cause a depression. The United States after 1946 is such a case.
The classic case in modern history was West Germany after the currency reform of June 1948. The economics minister, Ludwig Earhard, unilaterally abolished price and wage controls. This was on a Sunday evening. The next morning, hoarded goods began to reappear. This was the beginning of what came to be known as the German economic miracle. It was a miracle in the same sense that any modern economy is: a complex system of coordination that no civil government committee or group of committees can understand, let alone match.
Let us consider the second alternative.
STAGE THREE: HYPERINFLATION
Hyperinflation is when money dies. The official currency buys little of value. Output falls. People are reduced to selling off heirlooms and luxury goods for alternative currencies: gold coins, silver coins, and that most widely accepted currency, cigarettes.
The classic modern case of hyperinflation is Germany, 1921—23. A readable book on this social disaster is Adam Ferguson's book, When Money Dies (1975). It is subtitled, "The Nightmare of the Weimar Collapse." You can read it here.
An older, more academic, and widely respected book is Constantino Brresciani-Turroni's The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany (1931). It is available free here.
Whenever a contemporary economic analyst predicts hyperinflation in the United States, he is likely to offer the German inflation as his example of how bad things can get. The problem with this approach is that it ignores the last nine decades of American urbanization. We do not live in post-World War I Germany. We do not live in the relatively low division of labor society of post-War Germany.
In 1921, Germany was a militarily defeated nation. It had gone through years of price controls and rationing. The war had destroyed urban capital. The population was still mainly rural or small town: around 70%. There were about 60 million people. The largest city was Berlin, with about two million people. No other city was over a million, and most of the dozen large ones were in the 600,000 range.
The degree of specialization in Germany in 1921 compared to the United States today was minimal. Food was available without long supply routes from farm areas into cities. Money was mainly currency. It was not fractionally reserved digital money in banks. Most people did not have bank accounts. People could barter.
Today, hyperinflation would threaten supply lines into cities: food, gasoline, coal (electrical power). It would threaten the production of crops, which is a highly mechanized business. It would make food costs central in household budgets. Instead of spending about 10% of our income on food, as Americans do today, we would likely spend half or more. Unemployment would be widespread — the people not producing vital services.
The breakdown of modern urban society is unthinkable. Central bank economists know this. They are urban. They are tenured or close to it.
I do not think central bankers will move to a hyperinflation scenario. To do so would be opposed to their personal self-interest. At some point, they will tell their respective treasury departments, "you're on your own."
Then will come the great default.
Money today is monetized debt. Central banks and commercial banks monetize debt.
If they move to hyperinflation, they will kill money. When money dies, urban people will die.
If they do not move toward mass inflation, they will create a new Great Depression. We almost had this in late 2008.
There is no pain-free way out of this dilemma. Central bankers want to delay the day of reckoning. So do politicians. So do investment fund managers.
The governments are all running huge deficits. Central banks follow policies of low interest rates. The extent of the prior misallocation of resources is becoming harder to conceal.
The powers that be will cease to be powers if money dies. They have based their political control and their wealth on their control of digital money. This is the line to which the hook of state power is attached. To destroy the currency is to break this line. Better a new Great Depression than hyperinflation, if you are a central banker.
If money dies, a lot more than money will die. This includes Bernanke's pension. He knows this.
October 28, 2009
Copyright © 2009 Gary North