Global Risk Watch: Hyperinflation Revisited
Hyperinflation: Paper money only has a value because of the confidence that the money can be exchanged for a certain quantity of goods or services in the future. If this confidence is eroded, hyperinflation becomes a threat. If holders of cash start to question the future purchasing power of the currency and switch into real assets, asset prices start to rise and the purchasing power of money starts to fall. Other cash holders may realize the falling purchasing power of their money and join the exit from paper into real assets. When this self-reinforcing cycle turns into a panic, we have hyperinflation. The classic examples of hyperinflation are Germany in the 1920s, Hungary after the Second World War, and Zimbabwe, where hyperinflation ended in 2009. Indeed, hyperinflation is not that rare at all. Economist Peter Bernholz has identified no fewer than 28 cases of hyperinflation in the 20th century.
Our monthly global inflation barometer tracks the risks to our global
inflation outlook as part of our “Global risk watch” series. Apart from
deflation and high inflation, we identify hyperinflation as a third
risk to our view of moderate global inflation rates. We currently see it
as very unlikely that any of these three risk scenarios will
materialize over the next 12 months, i.e. we estimate their probability
at below 10%. However, given the devastating effects hyperinflation would have, we want to explore the risk of hyperinflation in more detail.
Hyperinflation has little to do with "normal" price inflation. In
particular, hyperinflation is not an escalation of "normal" inflation.
"Normal" inflation denotes a steady and continuous decline in the
purchasing power of money, which is ultimately attributable to an
increase in the money supply.
Hyperinflation, on the other hand, is a collapse of confidence in
money, which results in an accelerating flight out of money into real
assets and goods, and thus an accelerating loss of the purchasing power
of money.
Hyperinflation is a fiscal phenomenon
Ultimately, hyperinflation is a fiscal phenomenon; that is,
hyperinflation results from unsustainable fiscal deficits. Peter
Bernholz notes that historically, cases of hyperinflation have been
preceded by the central bank monetizing a significant proportion of the
government deficit. After investigating 29 hyperinflationary episodes,
28 of which happened in the 20th century, Bernholz writes: "We draw the
conclusion that the creation of money to finance a public budget deficit
has been the reason for hyperinflation."
When government deficits become unsustainable, austerity is often the
first reaction. Austerity is deflationary, recessionary, and painful.
If the austerity necessary to balance the budget is deemed to be too
painful, a government can either choose to default or to inflate the
currency.
If the country concerned has its own currency, it will usually choose
to inflate it. If government finances do not improve sufficiently,
confidence in the currency may evaporate at some point and
hyperinflation may arise. Hyperinflation is more closely related to
deflation than to "normal" high inflation, as hyperinflation can be
viewed as the result of a failed attempt at printing money to avoid the
deflation that would be caused by austerity.
In our view, there is some risk that hyperinflation could arise in one or more large currencies. As
a consequence of the burst credit bubble, we are seeing unsustainable
government deficits in many large countries. Deleveraging and austerity
are deflationary and recessionary. Central banks around the world are
fighting these deflationary and recessionary tendencies by massively
easing monetary policy. Having exhausted the interest rate instrument,
global central banks are increasingly turning to the alternative
measures of quantitative and qualitative easing (see Box). While direct
government debt monetization by central banks is still the exception,
the elaborate toolbox of central banks allows for indirect debt
monetization, for example, by accepting government bonds as collateral
in temporary but repeated operations. In the two following sections, we
illustrate the current unsustainable developments in global fiscal and
monetary policy.
Government debt rising at an unsustainable speed In the wake of the financial crisis of 2008, government deficits increased massively around the world. However, despite widespread commitments to austerity, government deficits are still at unsustainable levels (see Fig. 1).
Government debt rising at an unsustainable speed In the wake of the financial crisis of 2008, government deficits increased massively around the world. However, despite widespread commitments to austerity, government deficits are still at unsustainable levels (see Fig. 1).
According to International Monetary Fund (IMF) estimates, the
combined government net borrowing of the world's 10 largest deficit
countries will amount to USD 2.657 trn (or 5.9% of GDP on average) in
2012, half of which is due to the US alone. The 2012 deficits are only
slightly lower than the deficits in the three previous post-crisis
years. Before the financial crisis (1990–2007), average net borrowing of
the Top 10 deficit countries amounted to 3.7% of GDP; from 2009–2012,
net borrowing climbed to 7.4% on average. Average annual nominal GDP
growth since 1990 has amounted to 5% in these countries. In order to be
sustainable, i.e. in order for a country's government debt/GDP ratio to
decline, its deficit must fall below the nominal growth rate of GDP.
Given the current low growth and inflation environment, the deficits
would actually have to fall significantly below the 5% mark in order to
stabilize the debt/GDP ratio. Note that the 2012 IMF forecast of a net
borrowing of 5.9% for the 10 high-deficit countries could well turn out
to be too optimistic, as the recent negative economic news has worsened
the fiscal outlook.
Global monetary policy expansion accelerated
Fig. 2 illustrates the accelerating expansion of monetary policy
after the financial crisis of 2008. In the years leading up to the
collapse of Lehman (2002–2008), the global monetary base grew at an
average annual rate of 10.5% (in local currencies, weighted by GDP).
Since the Lehman collapse, the average annual growth of the global
monetary base has more than doubled to 21.6%. Currently, the global
monetary base amounts to USD 14.1 trn and is up 20.4% on the previous
year.
Fig. 3 shows the global monetary policy expansion and the combined
net borrowing of the Top 10 deficit countries. In fact, in 2011, the
global central bank balance sheet and the global monetary base expansion
were about equal to the deficit countries' combined net borrowing.
Although central banks do not directly monetize government deficits
(with some exceptions), one can argue that central banks are at least
accommodating the current excessive governments deficits.
Neither the government deficits of many large countries nor the speed
of the current global monetary policy expansion are sustainable. If
government finances do not improve and the global monetary policy
expansion is not halted in time, hyperinflation could set in. However,
it is not clear how much fiscal and monetary policy can expand before a
loss of confidence in paper money sets in.
Countries at risk
Bernholz notes that preceding a case of hyperinflation, government
deficits usually amount to more than 20% of government expenditures, and
that deficits amounting to 40% or more of government expenditures
clearly cannot be maintained.
Of the Top 10 deficit countries, India, the US, Japan, Spain and the
UK all exhibit government net borrowing above 20% of government
expenditures (Table 1). However, Spain does not have its own currency
and therefore cannot trigger hyperinflation on its own. The government
net borrowing of the Eurozone as a whole amounts to only 11% of total
government expenditures.
The euro is therefore not a prime candidate for hyperinflation, as
long as the core countries do not leave the currency union. Although
India is one of the Top 10 deficit countries, an outbreak of
hyperinflation there would be of relatively minor concern to the global
investor. Unlike the US and the UK, Japan is a creditor nation and not a
debtor nation. In fact, Japan has the world's largest net international
investment position (see Fig. 4), while the US is the world's largest
net debtor. We think that a creditor nation is less at risk of
hyperinflation than a debtor nation, as a debtor nation relies not only
on the confidence of domestic creditors, but also of foreign creditors. We therefore think that the hyperinflation risk to global investors is largest in the US and the UK.
Indicators to watch
The more the fiscal
situation deteriorates and the more central banks debase their
currencies, the higher the risk of a loss of confidence in the future
purchasing power of money. Indicators to watch in order to
determine the risk of hyperinflation therefore pertain to the fiscal
situation and monetary policy stance in high-deficit countries. Note
that current government deficits and the current size of central bank
balance sheets are not sufficient to indicate the sustainability of the fiscal or monetary policy stance and thus, the risk of hyperinflation. The fiscal situation can worsen without affecting the current fiscal deficit, for
example when governments assume contingent liabilities of the banking
system or when the economic outlook worsens unexpectedly. Similarly, the monetary policy stance can expand without affecting the size of the central bank balance sheet. This
happens for example when central banks lower collateral requirements or
monetary policy rates, in particular the interest rate paid on reserves
deposited with the central bank. A significant deterioration
of the fiscal situation or a significant expansion of the monetary
policy stance in the large-deficit countries could lead us to increase the probability we assign to the risk of hyperinflation.
Gold – the canary in the coalmine
Due to its long standing as the foremost, non-inflatable, liquid
alternative currency, gold is the first destination for wealth fleeing
from paper money into real assets. Gold can be considered a
hyperinflation hedge, and its price can be considered an indicator for
the probability of hyperinflation. A sudden rise in the price of gold
would be a warning sign that the risk of hyperinflation is increasing,
in particular if it went along with a worsening of the fiscal situation
in the deficit countries and an easing of monetary policy. Not only
gold, but also other commodities, as well as the stock market, would
profit from investors fleeing from money and from government debt. Thus
a strong rise of gold, commodities, and stock markets, accompanied by a
fall in the currency and in government bond prices (i.e. a rise in
yields) could signal the approach of hyperinflation. We will
continue to monitor global inflation developments and change our risk
assessment in the global inflation monitor according to current events.
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