0:33 Intro. [Recording date: October 19, 2012.] Russ: Topic is hyperinflation. What is hyperinflation? Guest: Traditionally it's been defined as any rate of price increase that exceeds 50% in one month. The person who did the work and eventually defined it was Professor Phillip Cagan, who was at Columbia. That was the origin of the 50%, and since then it's been traditionally used by everyone who is studying hyperinflation. Russ: And, historically some famous hyperinflations would include the Weimar Republic in Germany, right, in the 1920s? Guest: Yes. That one actually peaked out in October of 1923. But it was only the 5th highest one in the world, and it was much below the big high ones above it. Russ: What are some of those? Guest: Well, it peaked out in October of 1923--this is the Weimer--at 29,500% in one month. Now, that's an awfully big number. Russ: It seems like it. Guest: But if then we jump up to number 3--and by the way, there are 57 countries that have had hyperinflation--that was Yugoslavia in January of 1994. And that one was 13.3 million percent. So, we are going Germany, 29,500 up to 13.3 million. In Zimbabwe in mid-November of 2008, it peaked out at 79 billion percent, in a month. And then Hungary has got the number 1 spot, July 1946; I'm not going to give you all the zeros but that one peaked out at a daily equivalent rate of 207% in a day. Russ: Now, it's hard to relate to those numbers. Guest: Yeah. It's very hard to relate. This piece I did with one of my assistants, Nick Kruz--we listed all 57. We've documented now all known. Some weren't known until we did this piece, that will eventually be appearing as a chapter in a book. Right now it's a Cato Working Paper. But to get your head around the numbers, the monthly rate gets so high that the best way to do it is to translate them into daily equivalent rates and then another thing that we've done is have a metric for the time required for prices to double. So, in Hungary, that huge inflation that's number 1, the prices were doubling in 15 hours. Zimbabwe, 27.4 hours. Yugoslavia, 1.4 days. And so forth. The thing that kind of intrigues me about it, and the reason I kept pushing ahead with this research, which was kind of onerous basically to get all the metrics organized and find all the cases and actually come across some cases that have never been reported before--out of the 57 cases I've been involved either directly or closely with the stopping of 10 of the 57. So, as they say, I've had some experience with stopping these. Russ: Before we get to that, though, let's talk about--well, I actually just want to talk first about the logistics. When prices are doubling every 15 hours--is that really a meaningful phenomenon in terms of trying to measure it? If you are actually making transactions at those prices, you are getting up early. Every second you are losing money. You can't scratch your ankle on the way to the store. Guest: Yeah. It actually is meaningful in the sense that the unit of account you are using isn't the hyperinflating currency. The unit of account you are using is solid currency. It was gold in Greece, for example. Now, it's typically the U.S. dollar. So, anything that a merchant wants to sell you, they will first think in terms of how much in dollars, and then they'll translate. Usually they'll get on their cell phone and ask a dealer what the rate is for whatever the local currency is vis a vis the dollar. And if you've got local money, they'll charge you that. Or maybe they'll charge you that plus a premium, because they are going to have to run down a moneychanger and change it. Russ: Right. Guest: Depending on how fast they are will be the premium that hey charge you. Russ: But if there is no available obvious alternative to the local currency that's having that problem, pretty quickly the economic system breaks down and you are in a barter economy, right? Guest: Well, you do have a lot of barter. Let me give you the Yugoslav case because I was there. I was the adviser to the Markovic government. Now this was before the hyperinflation, but right before--it was in 1990 until the middle of 1991. And barter was occurring. And what you would do--let's say you had relatives; let's say you were in Belgrade. All your relatives out in the country would be supplying you with foodstuffs. And other transactions in Yugoslavia were always taking place in Deutschmarks anyway. Any significant purchase required Deutschmarks, and the reason why was that they had endemic and very high inflation in Yugoslavia: from 1971 until 1991 the average annual rate of inflation 76%. It was the second highest annual rate over that 20-year period that was recorded. Zaire was number 1. So, the economy, in a hyperinflation, or even in a very high inflation, what happens--yes, there is a lot of barter that starts seeping into the system. And basically the hyperinflation throws a monkey wrench into the economic system because you can't calculate costs properly. So it becomes very cumbersome. But the other thing that happens is that foreign currencies start being substituted for the local currency. Russ: Because people don't want barter. Guest: You get currency substitution taking place. And in a place like Zimbabwe, for example, what happened with that hyperinflation is that eventually people just stop using the Zimbabwe dollar. In November of 2008. It came to an end, and there was spontaneous dollarization that took place, where the U.S. dollar and to some extent the South African rand and a few other currencies from borderline countries crept in, and the Zimbabwe dollar just wasn't used. For anything. Russ: Right. Guest: And the next step was that the government was forced then to officially dollarize the country and change the budget and require taxes and so forth to be paid in dollars. So, the Zimbabwe dollar is gone now, and Zimbabwe is officially dollarized. Russ: So the trillion dollar Zimbabwe note that one of my students sent me--you are saying that's worthless now. I'm very disappointed. Guest: Well, on e-bay it has a lot more value than it ever did when it was circulating.

9:39 Russ: So, this is a softball question: What causes hyperinflation? There's a harder question behind that. Obviously what causes it is a rapid increase in the money supply. Guest: A very rapid increase in the money supply. And you get this--ultimately what causes the money supply to explode. Russ: Right. Why would a nation do that? Guest: That's the fiscal situation. And Yugoslavia for example, at the end, about 90% of all the government expenditures were being financed by the printing press. By the central bank. In other words, tax receiving were only about 10% of expenditure, so the budget deficit, in short, was running about 90%. Russ: And so, rather than cut expenditures or raise taxes, neither of which was politically appealing, they just printed the money and punished their citizens. They taxed people through this process we are talking about. They devalued any currency that people were holding and made their lives less pleasant. Guest: Right. Russ: So, we're going to talk about Iran in a few minutes, but before we do that, let's talk about the United States. Which--we are not having hyperinflation; but we do have a fiscal problem. We do have--we are spending a relatively large amount, relative to what we take in. We are spending a trillion more than we take in, a little over a trillion. We've done it for four years in a row. We did it before that in a significant amount as well. And people keep buying our bonds. And so it seems okay. But one of the institutions that's buying those bonds is the Federal Reserve. I've read that a very large portion of U.S. Treasuries are being purchased by the Federal Reserve. Can you explain that? Guest: Since they started the so-called Quantitative Easing. I think roughly since the Lehman collapse in September of 2008; I think it's about 75% of the total is being purchased by the Fed. Russ: So, can you explain to me what that means and what it portends for the future. Guest: Well, let's just start with Lehman's collapse in September 2008. That's a convenient date. Since that point in time, the Federal Reserve's balance sheet has increased roughly by three and a half times. So that means they are buying a lot of these bonds. And that's where they go, on the asset side of the balance sheet. Now that means that high-powered money, or what I call state money--the amount of money produced by the state--has more or less tripled. It's exploded. And this has many people concerned; and they get excited and say we are going to have hyperinflation tomorrow. That's a hyperinflation nexus. The Fed's buying all these bonds; their balance sheet is exploding; high powered money is increased very rapidly. And people conclude that it's going to be like Yugoslavia, or the Weimar Republic, or something like that. Now, it has meant that state money has increased from about 6.5% of the total money supply, when you measure the money supply properly with a broad measure, like M3--so we went from state money being at about 6.5% at the time Lehman collapsed, until now it's about 15%. So, you've more than doubled the size of state money. But the problem is: I said 15%; now state money is 15% of the total amount of the money supply--meaning that state money is peanuts. What really is important is bank money--and bank money is created by the commercial banking system and shadow banking system, and that's what really counts. So, in a way we have had the following scenario develop after Lehman: We've had ultra-loose monetary policy with regard to state money and the Federal Reserve. But with the financial regulation, that it was legislated with Dodd-Frank, and also with what is called the Basel capital requirements, and specifically Basel III, which is being imposed on banks--to increase the capital-asset ratios of the banks. These two things--financial regulation and Basel--have in effect imposed ultra-tight monetary policy on the banking system and bank money. So, as a result of the two, we've had the total amount of the money supply actually being very anemic, not growing very much at all. And in fact, if you look at a trend line since 2009 and look at the endpoint today of the trend line as you are going left to right, that point is about 7.5% higher than the actual level of the money supply that we have. So, you could argue that relative to trend we've got a deficiency of about 7.5% in broad money. And the reason why is that the dominating feature has been the reregulation of banks and the tight monetary policy imposed on bank money. Which accounts for 85% of the total amount of money in the economy. Russ: So, that's consistent with Scott Sumner's view, who argues that monetary policy has been very tight, rather than loose. Everyone looks at the so-called aggressive policy of the Fed. But my question then is: You are saying that banks have been highly regulated and you can also argue that the economic system is not very optimistic right now; it's kind of uncertain. But banks have huge excess reserves. So, you are saying they are constrained. But it appears they are very unconstrained. Guest: Oh, no: they are profit-maximizing. Banks are profit maximizing. So what happens is if you are imposing capital requirements on banks vis-a-vis Basel III, and you are requiring the capital-to-asset ratio of a bank to go up, how do you change that ratio? Well, one way to do it is to raise capital and increase the numerator in the capital-asset ratio. The problem with that is that the price of shares for banks now is much below the book value of the shares; and if you actually issue more shares and try to raise capital, you are diluting the existing share holders, when you have those conditions existing. And so the existing share holders don't want to raise more capital. So what you try to do is reduce the assets that you have and specifically what you want to do is reduce the risk-assets. Those that come under the umbrella of Basel III, that require a certain amount of capital-- Russ: High ratio-- Guest: to be set aside against them. So, here's what we've had since Lehman. Loans to commercial enterprises have gone down in the United States. Mortgages have gone down in the United States. Interbank lending has essentially disappeared--which is almost the lifeblood of the banking system, the interbank.

18:27 Guest: So, what's gone up? Because the total amount of the assets that banks have, the consolidated system, has gone up. So, what's gone up? One thing that's gone up: government bonds. Because government bonds are deemed to be risk-free by Basel. You don't need to set aside any capital to buy government bonds. So, government bonds have exploded--the holding of government bonds. The other thing that's exploded are, you mentioned excess reserves. Well, you've got cash. Cash has gone way up. So, banks find it profitable to avoid the Basel regulations in effect by accumulating government bonds and cash. And they make money at it, because there's a yield spread between the amount they are getting on the cash and the amount that they are having to pay for the amount they borrowed to go into cash, or go into excess reserves. Now, excess reserves--reserves at the Fed--are actually receiving interest. Russ: So, I've always been puzzled by this, so maybe you can help me. The story you've just told is that banks have rationally responded to the incentives of regulation and the Fed offering reserves to accumulate large excess reserves rather than issue more stock, rather than raise more money. As a result--or maybe I'm getting the narrative wrong--but at the same time, at least, the money supply is limping along, not exploding, despite the high increased balance sheet of the Fed. So, Ben Bernanke knows all this. He knows all these facts. They are not secret. You and I aren't the only people, and the listeners of EconTalk, that know that M3 is actually down, not up. What are they doing? What is your guess as to what they are thinking? Guest: Well, the big problem is, in economic lingo: we've been talking about, and I've been talking as a monetarist. An old-fashioned monetarist. And in particular, a broad money monetarist. Broad money counts, and it's the thing that dominates the economic picture. Russ: Broad meaning including bank money, not just state money. Not just reserves. Guest: Right. State money as well as bank money, ending up with something--the best measure we really have is what Professor William Barnett has been producing, and that's the Divisia M4; and that's the broadest measure and is measured correctly and so forth. And that's been lagging behind. Now, it's picking up just a little bit. But that measure is only growing at about a 4.5% per annum rate. I should say, year over year. The year over year rate of growth is still very slow in this broad measure. It's now relatively high compared to where it was a year or two ago. Russ: But, just to put it in perspective--hang on; let me re-enter you into the issue of Bernanke in a different way. He famously said, before he was Chairman of the Fed, I think in a conference with Milton Friedman: We've learned our lesson from the Depression when we let the money supply drop. Because bank money shrank during the Great Depression, dramatically, when we had all these closures and contraction of lending. And by bank money you mean all the liquidity that banks produce, their lending based on those reserves that they hold at the Fed. And so he said: We'll never let that happen again. And what you are saying is he let it happen again. Guest: Oh, he absolutely doesn't have a--he's probably one of the worst chairmen we've ever had at the Fed. He's strictly not a monetarist. There's no question about it. He's an inflation targeter. He's made his reputation as an inflation targeter, and as long as they are hitting that target, and now let us say it's in the 0-2% range, although one of the Fed governors, a president of a regional Fed, Evans, has indicated that maybe 3% would be an appropriate top level. We can get into that if we want to get out in those weeds and little bit later. Russ: No. I don't. Keep going. Guest: The bottom line is that Bernanke is not a monetarist and he's certainly not a supply sider. He doesn't have a supply side orientation on monetary policy. And the supply siders, they like to look at prices, not quantities. So, unlike a monetarist, who would be looking at the quantity of money, they would be keeping their eye on prices. Now, what do I mean by that? That means foreign exchange rates; the yield curve; gold; maybe a basket of primary commodities, 20 or 25 commodities. They'd be looking at things like that. And asset prices--the stock market as well as commodity prices as well as foreign exchange as well as interest rates and the yield curve. That would be kind of a supply side type of approach. The monetarists would be looking at the quantity of money, mainly. I'm actually looking at both, to tell you the truth. Whereas Bernanke--he doesn't even have those prices on his dashboard. If you look at what he's looking at, it doesn't include the dollar exchange rate. The critical thing--the dollar exchange rate, the price of gold. He claims he's not looking at those.

25:00 Russ: So, with the benefit of hindsight, what should he have done? Given that he's let M3 or M4, these broad measures of liquidity in the economy shrink? That's had a real impact on the economy; it's slowed the recovery; it's made it anemic. What could he or should he have done? A lot of people have faulted him for being way too aggressive. You are saying he wasn't aggressive enough. How could he have implemented a policy to make up for the shrinkage in bank money? Guest: Well, he could have come out against the Dodd-Frank financial legislation. That would have been maybe a politically dangerous thing to do, going head to head with Congress. But the other thing he could have done-- Russ: And you mention-- Guest: He could have put a freeze on Basel. Basel has a direct input into the capital requirements of the banks. But you see that, the reason the Americans love Basel III is that the European banks that the American banks are competing with in the international market, they are relatively undercapitalized compared to the American banks. So, basically, by imposing Basel III, you are mandating--you have a government banks that says that the European banks have to shrink faster than the American ones. Russ: Lovely. How did the European banks fail to get that fixed? They knew that, too, right? Guest: Well-- Russ: Or is this an unintended consequence? Guest: The origin of this is interesting. My diagnosis of the thing is that there was a--the crisis really started in August of 2007, and it happened in Europe and the United Kingdom in particular. There was a bank called Northern Rock. Northern Rock was a mortgage institution. It was solvent at the time and it was very profitable. And their funding source for the mortgage--they would lend long, long-term mortgage--is they were using money market funds issued in France. And in August, two of these French money market funds froze up. And so the Northern Rock people went to the Bank of England and they said: We need the lender of last resort; we are solvent; we are willing to pay whatever the penalty rate is and borrow from the Bank of England. Sir Mervyn King, head of the Bank of England, still is, said everything was fine; and they arranged to do this. But there was one little catch, and that is there was a reporter from the BBC that was friendly with somebody working at the Bank of England, and the trap at the Bank of England leaked the information that Northern Rock was going to get a substantial lender-of-last-resort loan from the Bank of England. And that was reported by the BBC. Well, what happened then--the depositors of course panicked because they said: it's obvious that Northern Rock is bust and they've had to go the Bank of England; and we want our money back. So you had the first bank run in a hundred years in the United Kingdom. And that really burnt the politicians. At the time, Gordon Brown was the Prime Minister, and Darling was the Chancellor of the Exchequer. And of course they ended up having to foot the bill for Northern Rock, ultimately going under. Which was a big bill. Because of this bank run business. Russ: I thought they were solvent? Guest: They were solvent; but what if every depositor comes in and they want their money today? Russ: Well, if they are solvent they have the assets to cover it. Guest: You've got a liquidity problem; you have to liquidate everything that you have to pay everybody off; and even though on paper it looks like you are solvent and you have good paper and you've got a profitable operation, you are forced to cough up the money. Russ: Yeah; I don't understand that; but we can come back to that or maybe skip it. Because, in theory-- Guest: At any rate, it was a liquidity thing. They needed to come up with the money. Basically they needed to liquefy their asset side of their balance sheet in a matter of a few days, and the only way they could do that is to have the government come in and bail them out. Russ: Well, okay. Guest: To pay the depositors off. And as a result of this of course there was a political price, and, as I say, Gordon Brown got burnt. He was holding the bill; the taxpayers were upset because they had to pay the depositors off that had wanted their money back from Northern Rock. And he led, then, this campaign to recapitalize banks. Everyplace. And it became an international mantra. And the herd followed. And that's where the Basel thing accelerated and got going. And then in the United States it came, and Secretary Geithner is a big advocate of recapitalizing banks. Russ: Yep. Guest: Part of it is a little bit disingenuous because it's advantageous to the United States relative to areas of Europe where they are undercapitalized and have a big gap to make up to get back to Basel III. Russ: By capitalized, you mean: Have a lower rate of leverage, meaning having a larger asset base rather than borrowed money to finance your operations, correct? Guest: Well, not asset base. Capital base. Equity. The equity is, remember, on the right-hand side of the balance sheet, so you've got to have a bigger equity and less borrowing on that right-hand side; and then on the left-hand side, that's where the assets are. And of course, you can increase your capital-asset ratio very quickly by just dumping assets and not raising any more capital. That's more or less what's been going on, because it's so unattractive to raise capital now, due to the fact that share prices are below book value for most banks. Russ: But the argument for this recapitalization is that if banks have more equity and less borrowing, they have a bigger cushion if their asset values fall. Guest: Right. Russ: That's the argument of Basel. Guest: That's the idea. It comes back--what you said about leverage is exactly right. It forces you to have less leverage than would be the case if you had a lower capital-asset ratio.

32:32 Russ: So, let's come back to this issue of the risk of inflation of a sizeable amount in the United States. I'm going to review how we got to where we are in the conversation. You argued--convincingly to me, but then, I'm a monetarist--that although high powered money, state money, you call it, reserves at the Fed: that's grown dramatically. It's more than doubled since 2008. Guest: More than tripled. Russ: But there was a shrinkage of lending and liquidity in the private sector--what you call bank money--so that the total money supply, the total amount of liquidity sloshing around in the economy has fallen. And as a result, our economy is hesitating. And hyperinflation is the last thing we have to worry about, despite the massive activity of the Fed. What Allan Meltzer would argue, and has argued on this program--and I don't know if he'd still argue it; it was a few years ago--his argument was: But eventually, when banks get more optimistic about the future and the economy starts to recover, then all those excess reserves, instead of sitting on the balance sheet of the Fed, they are going to go out into the real economy, and there will be inflation. So that bank money that had shrunk during the bad times will start to expand, and then the pressure will be on the Fed to shrink back its state money, its printing press money; and that's going to be politically unpalatable and we are going to get significant inflation. What do you think of that argument? Guest: Well, Professor Meltzer and I have corresponded on this, and as we've agreed--we generally agree on almost everything except this point. Russ: Okay, good; that's lively. I like that. Guest: And it does put one in a very awkward position, to actually be in disagreement with, shall we say, I think, the acknowledged dean of the Federal Reserve now, with his three-volume work on the Fed. So, let's get down to why I don't agree. You made Professor Meltzer's argument. That's still his argument. My argument is: If things start unfolding and banks get more optimistic and reduce the amount of cash they have and the amount of government bonds that they have and put it into commercial and industrial loans and mortgages and interbank lending and all these things, we will, in short, increase the level of the money multiplier in the system. So that high powered money, right now, the money multiplier that is associated with high powered money is let's say about 5 or 6, depending on what monetary aggregate you are looking at, relative to high powered money. But let's just say it's 5 or 6 relative to M3. What it was before the Crisis, it was about 12. So, the money multiplier is about half of what it used to be. And another way of looking at what Professor Meltzer is saying is that he's worried about once the money multiplier goes back to, shall we say, normal levels of 10 or something, that state money will kind of goose the system. It will end up bleeding through the banking system, the fractional reserve system. And even if there was no change in the volume of state money circulating, that you would have a huge increase in bank money because with the optimism, the money multiplier would go back up to normal levels and bank money would increase. And therefore the broad measure of money would ultimately increase; and yes, you would definitely have aggregate demand increasing and getting up to some level--let's say, in boom periods in the United States aggregate demand, the final sales by purchasers, gets up to 7.5 or 8%, something like that. And if growth is about 3%, long term trend rate of growth about 3, 3.1, or 3.2%, just subtract the 3.1 from the 7.5 and you've got inflation. So that is a concern. But the Fed should be able to realize the problem that they've gotten us into with this inflation targeting scenario; and the very lower interest rates, big expansion of their balance sheet. I'm not saying that that's been a good policy. But the reality is that's what they've done. And they will have to face the music under the Meltzer kind of scenario. And what do they do? Russ: He says they won't want to. Politically it will be too unpleasant for the Chair of the Fed to be called in front of Congress to ask why he's taking away the punchbowl before the party is even getting started. Guest: But that's always something that a Fed Chairman faces. I would say that in this case, they should put Bernanke in the hot seat, for a number of things. Russ: Yeah, well, I'm with you there. Let me take an implication of what you said that I've asked many times on this program, which is: Why the Fed is paying interest on reserves? Are you suggesting the possibility then that the Fed is paying interest on reserves to compensate the banks for the unpleasant compliance with Basel III? This is a way to soften the blow? Guest: It allows them to make good money on risk-free assets, basically. And with these profits, to recapitalize themselves and increase the capital-asset ratio. And it gets back, yeah, to the Basel thing. It's a mechanism that allows the banks to do this. They are making very good money on so-called risk-free assets. At least as defined by Basel, they are risk-free.

39:40 Russ: So, the other day I was meeting with some people who were much savvier and much wealthier and wiser than I am. And they asked me about this issue. And they think the dollar--they are not the only people I've met who believe this--they think the dollar is going to disappear. They think there is hyperinflation coming; you ought to be buying gold. We don't give financial advice on this program, so we are not talking about that. But I'm talking about their perspective. They think the dollar is cooked: that the long run, to go beyond the immediate today and tomorrow--but the fiscal situation in the United States, we're going to end up like Zimbabwe. We are going to have too many promises that we've made to public pensions and to Medicare and Social Security; the Fed is already buying up all of those government bonds; they are going to keep doing that. And ultimately we are talking hyperinflation; the dollar is disappearing. So, you are not as pessimistic as they are. Guest: No. As far as gold goes, I like gold; I'm not making any recommendation, but I've done some. Various Bloomberg shows and so forth. But the problem is not going to be a Zimbabwe hyperinflation. If anything, the problem right now, today, is the fact that we have a deficiency in broad money, for the reasons that I gave--mainly because we have imposed ultra-tight monetary policy on bank money. That's what all these people--just missing the picture, basically. They are going on and on about state money, and the fact that state money is a portion of the total amount of the money supply has more than doubled since Lehman. But it's only 15% of the total. Russ: Yeah. I like your point. Guest: The big thing is bank money; and bank money is being crushed. And that's why, overall, my assessment is we have a little deficiency in the money supply. Not great[?] like they do in the European monetary system where you have places like Greece--where the deficiency is something like 45%. The gap between where I think they should be if they'd been following a trend rate of growth in the money supply and where the money supply actually is. You've got about a 45% gap. And all these countries in Europe that are really in trouble, the southern countries, they have huge monetary deficiencies. The only country in Europe that is on trend is Germany. All the other ones are running big deficiencies. Russ: So, let me ask a different concern that these folks have, which I also hear, which is: We are going to end up like Greece. We can borrow money right now for some reason--one argument is we're the tallest pygmy and everyone else has lousy, they are even worse. So, people will still buy our bonds. But as our debt-to-GDP ratio continues to rise, because of these fiscal issues, eventually people are going to stop buying our bonds; we are going to go bust; and we are going to print up money. Guest: Don't get me wrong: I am with them; now you are talking about something else. Russ: Yeah, I know. Guest: We are going to shift from this hyperinflation thing to the fiscal. Russ: Yeah. I'm shifted. Guest: And the fiscal situation is a very simple problem. We have a huge fiscal problem in the United States, and it bears some of the earmarks that you've just repeated. But the main thing here is that government expenditures relative to GDP, they are outside the range that we've observed in the United States since the end of WWII. They are very high. So the problem isn't not enough taxes. The problem is cutting government expenditures and getting government expenditures down in the zone again. Getting that number down from 25% of GDP at the Federal level to something like 22%, for example.

44:09 Russ: Well, I agree with you philosophically, but what's holy or sanctified about 19%, or 22%? What's the big deal? I agree with you that philosophically, 25% government--I don't like what they spend it on. I don't see that that's a good allocation of resources. But that's my philosophical position. I could try to make a case for it empirically. But why is it a crisis? So, what's 25? Big deal. Guest: Well, here's the crisis. Once you get out of the zone that we've been in since WWII, no matter what political party--it's not really a partisan thing. In fact, fiscally the most prudent President we've had has been Clinton. Russ: Correct. Guest: President Clinton actually reduced government expenditures as a percent of GDP over his two terms by 3.9%. Now, there's no other president that even comes close to that. In the last two years that Clinton was President, he actually was running a fiscal surplus. I remember the big deal then. The big panic. The folks you were talking with about what's going to happen with hyperinflation and the bonds, their big panic was there wouldn't be any government bonds. There wouldn't be any 30-year paper left in the United States. Russ: I didn't understand that. Guest: How would the economy run if you couldn't be trading 30-years? And the yield curve would disappear. And so on. So, here's the problem. There isn't anything magic, as you point out, about being in the zone. Russ: Let's say 20%. It's an historical level. Guest: Something like that. The problem is that we are in a new regime now. We are up above that level that we've been at. We're outside the range; and transitions and regime changes are a problem. It's a little bit like--they interviewed one of these guys that went down Niagara Falls in a barrel. And he survived and came out at the other end. And they said: Well, sir, how was that ride? And he said: Well, it was pretty calm above the falls and below the falls, but the transition was a bitch. And that's the problem we have. We are in a transition now. And if we stay above, it's going to be this kind of Niagara Falls kind of problem. There's no question about it. Russ: Why? Why? Guest: So, we have to figure out whether to go down the falls and undergo the transition, or whether we will dial back government expenditures and get it down in the range that we've been at historically. No matter what party, by the way. It has nothing to do with parties. Russ: But why is it like going over Niagara Falls? We just borrow more money. What's the big deal? Guest: Well, you raise the specter. If you are having to borrow a trillion dollars a year, that's a lot of bread, as they say. Russ: The world capital market is pretty big. Guest: The capital market is pretty big; we'll have absolutely no trouble doing this today. You can see it reflected in the interest rates and the shape of the yield curve and the rest of it in the United States. There has been no problem. But the markets run on expectations. And if you expect this kind of borrowing as far as the eye can see and no dialing back on government expenditures or dramatic increases in taxes, eventually you will have a problem with the markets. Russ: You'd think so. Guest: The markets will eventually see through it. They might not do it tomorrow, but eventually they will. And then what would happen? Guest: In that case interest rates will simply go up. Right? And, you get a lot of squeezing out of private activity. Right now, you see, the problem in the United States--they are complaining, your friends, about the specter of hyperinflation and all the rest of it, and loose money. But the reality is, we are in a credit crunch in the United States for the reasons that I've given. Money is very hard to get. Russ: What's the evidence for that? I've heard that, that it's hard to get. Guest: Well, you look at the Federal Reserve System; they survey businesses and private individuals, the sort of non-bank public. And you look at the surveys that they do, and you don't have to be a rocket scientist to figure out that people want to borrow money and find it difficult to get it. Russ: Despite the fact that it's everywhere, supposedly. There's all this money in the system, but you can't get it. It's a paradox. Guest: See, this is--let's look at mortgages, just to get it down to ground level. Mortgage rates are at record low levels. But the problem is getting one. Because you have to meet standards. There is non-price rationing going on, to use economic jargon. And the standards required to obtain a mortgage or a loan are simply higher or more onerous than they have been in the past. And that's how the supply of mortgages is being rationed. A lot of non-price rationing is going on. Russ: I've heard that. I think it's true. I've talked to mortgage brokers and real estate folks, and they do say it's very hard to get a mortgage despite the fact that the rates are really low. You'd think at that rate--the question then is: Why are the rates so low? Guest: Well, the rates are low because the Fed has stepped in with this Operation Twist. They are buying on the long end. Russ: But their argument, you are saying, at this low price there are a lot of people that want the money. They are just, for non-price reasons, they are not being allowed to get it. Guest: One of my friends in Baltimore, he'd applied for a mortgage; and he was in a position to move from the suburbs down to the end of the inner city, an apartment. And he applied. And the problem is the apartment was in an old apartment building and there weren't any comparable sales. Russ: For the assessment. Guest: And as a result of there not being comparable sales in the area, he could not get a mortgage. And this went right up to the day that the closing was supposed to occur. He wanted to move; his wife wanted to move; all the rest of it. And so, to tell you how risky this guy was: He had enough money in the bank, he just paid cash. He closed; he didn't want to miss the closing. He wanted the apartment. But the bank led him on until literally two days before the closing they finally flipped the red flag up on him. And the reason they did is because of the requirements of Fannie Mae and Freddie Mac. They required comparable sales for evaluation. And the bank itself wanted to unload those mortgages on either Freddie or Fannie--I can't remember which one right now. So, that was the thing that queered it. Now this was a non-price rationing kind of thing getting thrown into the picture. Russ: I've heard that, too.

52:47 Russ: I invited you to be a guest on EconTalk to talk about Iran, because you'd written something very provocative on that. And I started off with our discussion of hyperinflation to get to that. And we have now made a very long, 40-minute detour in the U.S. situation. Which I'm very grateful for. But I'd like to talk in our closing minutes about Iran. Because it's an example of hyperinflation, and it will maybe bring us full circle. You argue that Iran is experiencing a hyperinflation of about 70% a month--the 50% being the benchmark. How do you know that? You are I think the only person who has noticed. People have noticed that there is inflation. But you claim to measure it. How do you measure that, and why is it happening? Guest: The way you do this is the way I did it for Zimbabwe. You see, Zimbabwe, they stopped in June of 2008 reporting any kind of hyperinflation, any inflation numbers. But the one thing that was going on, there was a black market in the currency. And if you know the change in the value of a local currency vis-a-vis the U.S. dollar, then you can impose what's called purchasing power parity, and make a calculation and easily determine what the rate of hyperinflation is. Russ: A rough guess. Guest: So that's the mechanism. So, there's one free market price in Iran, and that's the black market rate. I've got good information on what the black market rate is. Russ: How do you get that? Guest: So, I can look at the changes in that free market price, which is an objective measure of value, and from that I can make a calculation about the implied inflation rate that's facing the Iranians. Russ: How do you get that? Guest: Those are the steps. It's just a two-step process. Russ: How do you get the black market rates, though? Where do those come from? Guest: Well, there are various sources. One that I've been using, the Association of Exchange Rates in Iran, has been reporting these. Now, once I detected hyperinflation and published that, they shut down all the websites and I couldn't get this information for a few days. Now I have a way of obtaining it, and I have a good time series on what the black market rate is. Actually, they have a multiple exchange rate, so the official rate is 12,260 Iranian rial to the dollar. That's for a couple of categories of items--actually two: medicines and high-priority items, you get a very good rate if you qualify on that; and you get that at the central bank. And then, there's another rate of about 25,400 that you get through licensed dealers; that's kind of a controlled rate, too. And then there's a black market rate that's free. And so you basically have three prices for the same thing in Iran. And of course all the distortions that come with that kind of multiple exchange rate system they have. Russ: So, why are they experiencing hyperinflation? Guest: Well, one reason--hyperinflation, you mention early in the show, is always a monetary phenomenon. So, there have been very rapid increases in the money supply since 2010 in Iran. But in addition to that, you've had what's kind of akin to bank runs in currency markets, and that is you have panic sellings of rials every once in a while. Or to think about it in a different way, the demand for rials just collapses. Everyone wants to get out of the rial and get into gold or U.S. dollars because they anticipate bad times down the road. Maybe they anticipate that the black market will be totally shut down and it will be very hard to exchange any currency, so maybe they want to get out for that reason. It's an expectations thing. The people on the street expect the rial to decline in terms of its purchasing power and they want to get something that's going to retain purchasing power. And from time to time you get these big plunges in the exchange rate. And when you get the big plunges they've experienced in September and October, of course that leads to the implied inflation rate being very high. And then I can go back and just look at the press and the price of a key commodity--chicken. And it matches up almost perfectly with the calculations I'm making from going from the black market exchange rate to the implied inflation rate. And I've done this with a number of countries. As I say, I've studied all these 57 episodes of hyperinflations. So, the analysis works very well. And we had, by the way: the Weimar Republic, the place where this approach of going from the exchange rate to the implied inflation rates using purchasing power parity--actually it was Jacob Frenkel, distinguished economist who did one of the classic studies on this. And Frenkel published in the Scandinavian Journal of Economics back in 1976 something called "A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence". And that was all about the German case, where he just clarified the whole picture and validated this approach that I've summarized to you. Russ: So, just for our nontechnical audience: Purchasing power parity is exploiting the fact that goods of similar quality have to sell for similar prices across the world, if they are tradable. Guest: Yes. Russ: That's what you are exploiting when you try to-- Guest: Yeah, exactly.

59:47 Russ: So, do the sanctions that the United States and Europe have put on Iranian financial transactions--is that part of their hyperinflation? Guest: Well, that's part of the panic selling kind of thing and the collapse in the demand for the rial. The sanctions come in through that door, and changing people's expectations in Iran and motivating them to try to unload what they think will be a depreciating rial and getting something that they think will be more solid. But, that's on the one hand. On the other hand the history of sanctions has usually been counterproductive. Russ: Correct. Guest: Usually sanctions, when they are imposed, tend to keep your enemy in power and force a regime change. Russ: I think they are mainly for the home country. Guest: And the thing that is concerning to me about sanctions in Iran is that not only can they be counterproductive, but they can be outright dangerous because the Iranians control the Strait of Hormuz. And if the sanctions get tighter and tighter and tighter, and oil can't be sold--any oil can't be sold by the Iranians--they have virtually nothing to lose by shutting down the Strait. If they did that, 35% of the world's crude oil comes through the Strait; and 20% of the liquefied natural gas [LNG] in the world comes through the Strait. So, the mullahs, in short, have an ace up their sleeve. And we don't want them to ever play it. We don't want the Strait of Hormuz to ever be shut. Because we really would have an economic mess on our hands if we had all of a sudden 35% of the world's crude being cut off and 20% of the LNG. Russ: Well, I think we know how that ends up. Guest: Yes. Russ: They don't end up controlling the Straits, but that's war. Guest: Well, I think what you end up with then is unless we can figure out some kind of diplomatic solution to the Iranian problem, we simply have something shaping up that will have either a horrible end or a horror without end. One of the two.