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Sunday, January 6, 2008

Hyperinflation - Could it Happen in the USA?

Could the US economy suffer from a hyperinflationary collapse, just like other countries have? Some economic historians say that a hyperinflationary collapse is the only way a fiat monetary system can end. None of the countries using fiat monetary systems have had the same currency for more than 100 years. The US is the oldest surviving fiat currency. Most European countries had their currency collapse to zero during WWI or WWII.

The US has had fiat money since 1913, 1933, or 1971, depending on how you count. In 1913, the Federal Reserve was established. In 1913, the Federal Reserve started printing more dollars than physical gold was in the US treasury. In 1933, President Roosevelt stole all the gold from US citizens. US citizens were unable to redeem their dollars for gold, although foreign central banks still could. In 1971, the US government defaulted on foreign countries' ability to convert dollars to gold.

Since 1971, not a single currency in the world has been convertible to gold or a tangible asset. Other countries use US dollars as reserves as if they were still backed by gold.

China has a huge amount US dollars and government debt. The saying is "The US is exporting its inflation to China". China is willing to load up on US dollars for several reasons. First, China views full employment for its people as more important than a bookkeeping profit on its dollar reserves. Second, a lot of US technology and factories are being exported to China. Third, this huge dollar holding gives China huge leverage it can use in negotiations with the US.

When a Chinese business sells products in the US, the Chinese business is paid in dollars. The business then turns its dollars over to the Chinese government in exchange for newly printed yuan, China's currency. The Chinese government is simply holding onto these dollars, investing them in US government bonds. The money supply in China is increasing, because Chinese businesses are exchanging their dollar surplus for newly printed yuan. China's government is just sitting on these dollars. This means that the money supply in China is increasing while the amount of tangible goods in China is staying the same. The US is, quite literally, exporting inflation to China.

For how long is China's government willing to accept a 5-10% loss per year on its dollar holdings? The value of China's dollar holdings are being eroded by 5-10% per year due to inflation.

China could, if it wanted, trash the US economy and show a profit at the same time. It would be just like in that "Trading Places" movie, where the two main characters make a fortune and ruin their enemy at the same time.

China could wreck the US economy in 5 minutes and simultaneously show a profit. China could, on every single dollar-denominated futures market, at the exact same time, buy the maximum amount of dollar-denominated assets it could. Each futures market has a limit to how much the price can move in one day. Suppose that China bought as much as it could, pushing the market limit-up in gold, silver, oil, copper, iron, food, etc., ALL AT THE SAME TIME. It would have to be well-coordinated, so that the buy orders would be placed on every exchange simultaneously. China could probably push every single market limit-up and still not have spent all its dollars.

China could start converting its US bond holdings directly to cash or short-term bonds, so it wouldn't lose when the US has to raise interest rates to fight hyperinflation.

The point is that China can dump all its dollar holdings in a few minutes. When other countries found out that China was selling dollars, they would see that the inevitable run on the dollar had started. Everyone else would start dumping their dollars.

The value of a dollar would collapse. Then, having initiated the run on the dollar, China could buy back its dollars after the dollar tanked. It probably would wind up with more dollars than it started with, plus all the commodities it had bought.

What would happen from the point of view of a person living in the US? I'm not sure what percentage of the total outstanding dollars are held by foreign countries. Suppose that 50% of the outstanding dollars are held outside the US. When other countries simultaneously dump all their dollars, these dollars will find their way back to the US. In other words, prices in the US would approximately double.

Suppose prices did double in a month. Would that be the end of hyperinflation? No, because once people in the US see inflation is out of control, they will refuse to hold dollars. Anyone who receives dollars will immediately spend them before prices go up. They'll spend their dollars on retail goods or gold or stocks.

What happens at the start of hyperinflation is not just an increase in prices. What also happens is that the velocity of money increases. When a currency is rapidly being devalued, people will refuse to hold onto it. Anyone who acquires rapidly inflating currency will try to spend it as fast as possible. This increases the effective amount of money in circulation.

What would happen if the Federal Reserve raised interest rates? Bond yields would rise. The Compound Interest Paradox would suck money out of the economy. But, all the new Treasury Bonds auctioned would be at a much higher rate. More dollars would need to be issued to pay off the bonds.

The way the system would break is that the income tax system would fail. If I do a barter transaction in January, I do not need to pay the tax until later. Under normal inflation, the dollars owed in tax will be comparable to the value of the transaction.

In a hyperinflation scenario, if I do barter now, and pay income taxes later, inflation works in my favor. By the time I pay income tax, inflation has eroded the value of the transaction.

Hyperinflation would force people to return to using barter. Currently, income tax is a disincentive to using barter, but during hyperinflation income tax is an insufficient disincentive to bartering. Further, when people are using barter instead of dollars, the demand for dollars will drop even further, forcing dollar-denominated prices even higher.

Hyperinflation would also destroy banks. The loans they had issued would be repaid with now-worthless money. Their net worth would be a large number of dollars, but those dollars would now be worthless.

Hyperinflation destroys the financial system because it reduces the effect of income taxes penalizing people for doing barter.

There is another way the dollar could collapse in hyperinflation, via an agorist revolution. Suppose a lot of people started refusing to accept dollars as payment for working, switching to gold, silver, or barter. Suppose the people agreed to not report each others' work to the government for taxation and confiscation. As the amount of goods that could be purchased with dollars decreased, the size of the agorist economy would increase. Eventually, the dollar-based economy would be like a foreign country relative to the agorist economy. The dollar would collapse in hyperinflation. As the government collapses, the agorist community would provide the services formerly provided by the government, preventing total chaos from occurring.

1 comment:

Anthony said...

Hyperinflation is a scary scenario, but that's why I'm buying gold as fast as my college kid's budget will allow.

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