A Clear Understanding of Hyperinflation, Money Demand & the “Crack-Up Boom”
Hyperinflation is perhaps the darkest side of a government fiat money regime. Among mainstream economists, hyperinflation typically denotes a period of exceptionally strong increases in overall prices of goods and services, thus denoting a period of exceptionally strong erosions in the exchange value of money.
In further edited excerpts from the original article* Thorsten Polleit (www.mises.org) goes on to say:
Hyperinflation: A Definition
Some people consider a rise in overall prices of 10 percent per month (which implies an annual rate of price increases of around 214 percent) as hyperinflation; others indentify hyperinflation as a monthly price rise of at least 20 percent (which implies an annual increase in prices of nearly 792 percent).
The monetary theory of the Austrian School of economics teaches that inflation is the logical consequence of a rise in the money supply, and that hyperinflation is the logical outcome of ever-higher growth rates in the money supply.
According to the Austrian school, money is, like any other good, subject to the irrefutably true law of diminishing marginal utility… in which an increase in the quantity of money by an additional unit will inevitably be ranked lower (that is, valued less) than any same-sized unit of money already in an individual’s possession. This is because the new money can only be employed as a means for removing a state of uneasiness that is deemed less urgent than the least-urgent uneasiness which one has up to now been removing with the money in one’s possession.
Effect of Increasing Money Demand
People hold money because money has purchasing power and the purchasing power of money is determined by the supply of, and demand for, money. If a rise in the money supply is accompanied by an equal rise in money demand, overall prices and the purchasing power of money remain unchanged. Once people start to exchange their increased money holdings against other goods, however, prices will start to rise, and the purchasing power of money will fall. That said, it is the rise of the money supply relative to the demand for money that brings to the fore the obvious effect of an increasing money supply: rising prices.
Mises saw that money demand plays a crucial role for the possibility of an unfolding hyperinflation. If the central bank is expected to increase the money supply in the future, people can be expected to rein in their money demand in the present – that is, increasingly surrendering money against vendible items. This would, other things being equal, drive up money prices. Mises noted that “this goes on until the point is reached beyond which no further changes in the purchasing power of money are expected.” The process of rising prices would come to a halt once people have fully adjusted for the expected increase in the money supply.
What happens, however, if people expect that, in the future, the money-supply growth rate will increase to ever-higher rates? In this case, the demand for money would, sooner or later, collapse. Such an expectation would lead (relatively quickly) to a point at which no one would be willing to hold any money – as people would expect money to lose its purchasing power altogether. People would start fleeing out of money entirely, i.e. a “crack-up boom” would occur.
What Does “Crack-up Boom” Mean?
This is what Mises termed a crack-up boom: “If once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the ‘twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse).”
The Unrelenting Power to Inflate
If people expect a forthcoming, drastic increase in the money supply – but if they, at the same time, expect that such an increase will be limited (i.e., a one-off increase) – the central bank can actually orchestrate a debasing of money without causing its complete destruction. As long as government and its central bank succeed in making people believe that any future rise in the money supply will remain within an acceptable limit, from the viewpoint of the money holder, monetary policy is an effective and most perfidious instrument for expropriation and non-market-conforming income redistribution.
Murray N. Rothbard, in his famous essay ‘The Case for a 100 Percent Gold Dollar,’ saw the danger that the government-controlled fiat money could be held up and run indefinitely and that it would not necessarily drive itself into a fatal and final collapse. In fact, as long as people do not expect that a money supply increase will spin out of control, the central bank is in a position to debase the currency without completely destroying it. In other words: hyperinflation would be possible without destroying the money completely. The crack-up boom, as Mises pointed out, would unfold only when people come to the conclusion that the central bank will expand the money supply at ever-greater rates:
“When finally the masses wake up they become suddenly aware of the fact that inflation is a deliberate policy that will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”
Debt Levels
Today’s fiat-money regimes are characterized by ever-greater amounts of debt relative to real income – caused by policies that try to solve the economic problems caused by credit and money creation out of thin air by using even greater amounts of credit and money created out of thin air and the higher an economy’s overall debt level is, the more likely hyperinflation becomes.
To show this, let us assume that after a long period of money creation through bank circulation and credit expansion a credit crisis emerges. Creditors are no longer willing to roll over maturing debt at prevailing interest rates. Borrowers cannot repay their obligations when payment is due, and neither can they afford paying higher borrowing costs. Investors start fleeing out of bonds, making interest rates increase sharply and thereby covering up unprofitable investment. More borrowers, including banks, fail to meet their obligations, and bankruptcies spread. Ensuing recession and rising unemployment aggravate the collapse of the credit structure.
Should investors in the above situation expect that the government and its central bank would opt for bailouts financed through additional money creation, the demand for money and fixed claims would most likely dry up. This would make it necessary for the central bank to extend ever-greater amounts of money to struggling borrowers in order to prevent the spread of bankruptcies.
The larger the amount of outstanding debt is, the larger will be the potential increase in the money supply. The more the money supply grows, the more likely it is that there will be hyperinflation and a potential breakdown of money demand: the unfolding of a crack-up boom.
*http://www.gold-eagle.com/editorials_08/polleit012310.html
Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
http://www.munknee.com/2010/05/finally-a-clear-understanding-of-hyperinflation-money-demand-the-crack-up-boom/
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