Big Deficits and a Weaker Dollar
by Michael S. Rozeff
by Michael S. Rozeff
Hyperinflation in the U.S. hasn't happened for quite some time. The last two instances that come to mind are confederate money in the 1860s and the continentals in the 1770s. In both these cases, governments used inflation to finance wars because their tax systems were weak.
A strong tax system (from the government's perspective) has several aspects. It has a large productive capacity that it can tax without causing production to decline by a great deal. It can enforce tax collections. The required taxes are low compared to the overall government spending.
The U.S. tax system is not weak, but it is weakening. The productive capacity is difficult to evaluate, but it too has probably weakened. The U.S. economy has a large government sector (at least 40 percent) that is relatively inefficient. It also interferes with and distorts the private economy. The federal government has not been able to finance its spending by current taxes in a long time. Instead it has resorted to borrowing (deficit spending) and inflation. The results are a large national debt and a depreciating currency.
U.S. government financing has weakened further in the past year. The government is borrowing very heavily to pay for such actions as the absorption of Fannie Mae and Freddie Mac, bailouts of AIG and large banks, and the rest of the Troubled Assets Relief Program. A short while ago, the government sent out $160 billions of dollars of tax rebates. Meanwhile the Fed has, on its own and with government cooperation, vastly increased credits to the private economy. This has dramatically inflated the monetary base.
The prospects for further tax cuts and higher government spending are bright. In particular, the federal and state governments have made large promises in Social Security and Medicare that, if carried out, mean much higher future government expenditures. These cannot be financed by higher taxes, as they would be too high and crimp production. This spells greater deficit spending, which in turn raises the prospect of higher inflation. In fact, the Fed has already begun to buy more securities in the open market. This "monetizes" debt or creates base money that allows banks to increase lending if they so choose.
Hyperinflation is not an immediate prospect for the U.S., but considering the positions of both the government and the Fed, much higher inflation in base money and a rising price level for goods are both definite prospects. It is not too early to review what happens in a hyperinflation, if only to help discern and understand the kinds of actions our government and central bank are taking now. I focus on the German hyperinflation of 1919—23.
Hyperinflation has a single proximate cause, which is the central bank's large expansion of the monetary base. What causes such expansion? Large government deficits are one major cause. Fiscal deficits are financed by issuing treasury bonds. When the central bank buys these, it makes the monetary base rise. Government deficits, which have many causes such as wars and social programs, signal a weakness in the political and fiscal systems, which result in taxes not being high enough to cover government spending. The central bank itself causes an independent expansion of the base when it decides to issue credits to such entities as banks, businesses, and other central banks.
A major step in the course of a hyperinflation is a change in public behavior. The public decides to exchange depreciating paper for real assets such as goods and gold. When acted upon, this desire raises the velocity of money, causing the price level to accelerate its increase.
Suppose that the central bank begins an inflation by going off gold entirely, so that the currency is not convertible into gold. The next step is that the central bank greatly increases the monetary base. Perhaps it buys the government's bonds or issues credits to the business sector. The next critical step in hyperinflation is that the public stops accepting the currency as a medium of exchange and attempts to flee from using it. The reasons behind that are a loss of faith in the government. The public may decide that the government's deficits are too large for it to handle, or that the government is unable to address some overwhelming problems. Rising prices combined with social and economic problems that are out of control may hasten the public's disillusionment with the currency.
These steps do not occur according to any fixed time schedule. They vary in length and magnitude. They vary according to the specifics of a nation's economy and the situation of the government. They vary with actions that the government and the public may take. The size of the hyperinflation varies. In other words, the precise pattern of how the hyperinflation works out in practice varies from case to case. The above provides a loose and rough template.
The public's flight to hard assets and away from paper is a shift with no specific catalyst. However, when it occurs, it occurs very rapidly. It is a social phenomenon subject to rapid learning. The change in expectations about currency value spreads like wildfire or like a rumor. Still, the time span occupied by the whole episode can be several years.
The public's spending of its available money balances acts to increase the velocity of money that has already liberally been supplied by the central bank, money that is already in the banking system and economy. Velocity is the turnover of money into goods. The increase means that each person who receives paper money acts to spend it as quickly as possible; money changing hands rapidly means high turnover and high velocity. The result is that prices rise. There is no known theory that details the timing of the public abandonment of the paper currency.
The episode of German hyperinflation during 1919—1923 had its roots in World War I and the German central bank going off gold (suspending conversion) on July 31, 1914. The government did not have a strong enough tax system to finance the war, so it used inflationary finance: borrowing and central bank purchases of the bonds.
The German hyperinflation began in October 1918 and ended when the government introduced a new currency called the Rentenmark in April of 1924. In the buildup to the hyperinflation, the 5 years preceding 1918, the money in circulation rose by 440 percent. By comparison, that degree of growth (in M1) has taken the U.S. since August of 1978 or 30 years. The U.S. inflation has been far slower than the German inflation that preceded its hyperinflation.
Between 1913 and 1918, the prices of domestically-produced goods rose 239% in Germany while imported goods rose by 214%. In the U.S., the CPI has risen 326 percent since 1978. In both cases, the money growth accompanied and no doubt caused the goods prices to rise. In both cases, goods prices did not rise as much as money rose in this stage.
Gold or the U.S. dollar (at that time linked to gold) rose only 57 percent against the mark between 1913 and 1918. Since 1978, in the U.S., gold has risen from $193 to about $850 in 2008. This rise of 440 percent matches the rise in money in circulation. If 1979 is used as a base year, the gold rise is from $307 to $850, which is 176 percent. If 1980 is used, the rise is from $613 to $850, which is 39 percent. These data suggest that in the base period before hyperinflation occurs, gold had some tendency in Germany to lag behind the rise in money in circulation that had occurred. But in the case of the U.S., this does not seem to have been the case.
From October 1918 to July 1919, inflation continued. The German government increased its borrowing (by issue of treasury bonds) by 57 percent. The central bank bought these bonds, and money in circulation also rose by 57 percent. Domestic goods rose in price by 43 percent and imported goods rose by 66 percent. Gold went up by 129 percent. This meant that the exchange rate was falling substantially, making imported goods more costly.
The government, which was causing the inflation, operated on the theory that it was not causing inflation. As prices rose, the government thought that it was supplying the currency that people demanded. It blamed the inflation on a variety of factors, including the falling exchange rate. The latter was associated with higher prices for imported goods. Far from being the cause of inflation, the depreciating exchange rate reflected the central bank's inflation.
It was between August 1919 and February 1920 that hyperinflation took hold. The government issues of bonds rose 14 percent and the money in circulation rose 33 percent. However, internal prices rose far more: 185 percent. The velocity of money had increased dramatically. Imported goods prices rose 847 percent and gold rose 427 percent.
Gold's price overshot (or the exchange rate fell too far) because in the next period, February 1920 to May 1921, gold fell by 37 percent and the prices of imported goods fell 63 percent. This was not due to any less money growth or lower government bond issues, for treasury bonds were doubled in this period and money in circulation went up 50 percent. The cost of food rose another 39 percent. While this period showed a respite in what was to come, the continuing huge increase in the government borrowing and the consequent increase in money in circulation did not bode well.
The data on gold and goods prices in this period show clearly that hyperinflation is an uneven process in an economy. Prices do not all move mechanically in lockstep or in one direction. Speculative prices can undershoot and overshoot their eventual arrival points at different times. Although the large increase in government debt and money in circulation provided fuel for the next stage, velocity did not rise in this period. The flight from the mark had abated for a time. There was a respite or corrective phase that occurred. It was the calm before the storm.
From May 1921 to July 1922, once again government debt and money continued to rise at very high rates of 74 percent and 149 percent, respectively. The public reacted. Once again, the velocity rose steeply as internal prices rose 635 percent and imported goods prices rose 810 percent. Gold rose by 692 percent.
These data suggest that if the government keeps up the bond issues and if the central bank keeps buying them, then the public will recognize this process, even though there may be lags in that recognition of some months. When that recognition occurs, velocity will again accelerate and prices will rise steeply.
In 1922, the central bank started making commercial loans, an independent source of money creation beyond monetizing government debt. This caused the money in circulation to increase faster than the growth in government bonds. Gold and the exchange rate began to anticipate the movement of internal prices of goods.
In the period July 1922 to June 1923, gold and the prices of imports, which are linked via the exchange rate, soared by unimaginably high factors of over 22,000. Internal prices rose by a factor of over 18,000. Velocity was still rising, because money in circulation rose by a factor of over 8,500, which was less than the price rise factor. Government debt issues rose by a factor of over 7,100. As fast as the government debt issues rose, that fast did the central bank monetize them. And velocity rose even faster.
The final period of hyperinflation has such large numbers that they lose all meaning other than to say that internal prices, the price of gold, and the money in circulation all moved in close correspondence. At this stage, the economy enters a kind of pure quantity theory world in which velocity is some very high figure that has reached a practical physical limit, and in which every increase in money is translated into a similar increase in prices. Before that stage, as we have seen, there is room for lags and variations.
The detailed story of the German hyperinflation appears in the book by Bruscioni-Turroni available here, which provided the relevant figures reported above.
This brief summary emphasized the role of fiscal deficits. The U.S. government has a much stronger tax collection system than Weimar Germany. Yet, it is now running the largest official deficit in its history. In 2008, the treasury reports here that outlays exceeded receipts by $816 billion. In the last three months of 2008, the deficits were $485 billion alone. The 2009 deficit will easily exceed $1 trillion. Given the programs being passed and discussed, a deficit nearer $2 trillion is possible. A series of such large deficits is likely according to the Obama administration. The Fed has already indicated its intention to monetize the debt issues of the treasury to an unknown extent.
Political factors that are systematic are driving the weakening financial position of the U.S. government. The government is geared toward higher and higher spending. The public largely supports this. Higher taxes, however, are unpopular. The government is expected to insure and/or bail out all sorts of contingencies. These expectations are rising. The number of groups seeking relief is growing as the recession deepens. When government and its deficits reach a very high level, as they now are, the situation engenders hopelessness. Cutting small programs is rightly viewed as ineffective, while cutting large programs is viewed as politically impossible. The result is that government spending goes out of control.
The government has no firm commitment to getting its fiscal house in order. It has no firm plan that it has made public and committed to. Its promises are in the opposite direction. There is no credible plan to reduce expenditures, reduce borrowing, and use taxes to fund the government's outlays. The debt continues to rise at an accelerated pace.
Weak statements made by officials that they want to build a fiscally responsible government lack credibility without actions to back them up. The testimony of Timothy Geithner provides an example. When asked about the effect of raising current spending on long-run deficits, his reply provided no assurance other than an acknowledgment that such a problem existed:
"We must move quickly and boldly to get our economy back on track. It is also important, however, that our program to restore economic growth be accompanied by a clear and compelling strategy to get us back as quickly as possible to a sustainable fiscal position.
"It is critically important to balance short-run and long-run objectives, and I think it is right for us all to worry about whether certain stimulus measures could create another bubble or other detrimental long-run costs.
"I believe that President Obama's plan provides the appropriate type and level of stimulus to stimulate consumer demand quickly and save or create 3.5 million jobs for American workers, while also making an important down payment on strategic long term priorities such as reducing the cost of health care. This plan helps achieve both short and long term objectives and is an important strategy to put in place right away."
At several places in his testimony, Geithner emphasizes taking strong action now, which means running much higher deficits. (He believes that the actions must be so large that they restore public confidence and cause the public to start borrowing and buying again, or businesses to start investing again. That is his theory, at any rate.) He accepts the fact that this causes problems such as an unsustainable government fiscal position, but he is unable to articulate any specific plan of action to deal with that looming problem that the government's spending actions will cause. His statement is to the effect that he believes that the Obama plan will stimulate employment and that this will raise production and create government revenues.
We have heard this theory countless times in the past, but the growth of the government debt has yet to abate. We know in the Weimar Germany case that vast increases in government bond issues and inflationary finance disrupted the entire economy. They did not lead to reduced government borrowing but to greater government borrowing. This is the history of the U.S. economy since the year 2000. Increased borrowing at all levels of the economy has led to a large-scale recession, reduced government revenues, and greater government borrowing. This lays the foundation for greater inflation in the future.
Geithner's other theory is that the Obama health care plan will improve efficiency in the health care sector and reduce government spending and commitments to Medicare. In light of the history of the government's intrusions into health care, this theory is nothing short of pure fantasy. We can expect the opposite of what Geithner hopes for.
Geithner's statements tell us plainly that the federal government will vastly increase its expenditures while having no real plan in place to stem the future red ink. No plan, no commitment, no credibility. Holders of assets denominated in U.S. dollars should take note. The finances of the U.S. government are weakening, and this is the planned policy of the Obama administration. There are no credible plans in sight that have been made public to alter this in the long run. There is rather weak talk from the President's advisors but no plan. Future federal commitments loom large. Federal guarantees and bailouts are large and growing. Federal deficits are already huge. All of this points to a weaker dollar.
February 4, 2009
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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