From Alasdair Macleod of FinanceAndEconomics.Org

The mathematics of hyper-inflation

We have already passed the point of no return on our journey into hyper-inflation for many paper currencies, and investors seeking to protect themselves from currency debasement should understand why. This opening statement is valid even if we ignore today’s abounding systemic risks.

There is a simple reason why monetary inflation becomes an exponential phenomenon. As currency is debased, an increasing quantity of money is required to achieve the same real-money effect. For example, if the quantity of money is increased 25%, the initial benefit to the issuer is a tax of that amount on the holders of previously-existing money stock. To achieve the same tax in real terms for a second time requires a further expansion of 31.25% of the original monetary units, and continuing with subsequent 25% expansions on increasing totals we obtain our exponential series of monetary inflation.

In practice, the realisation of the loss of purchasing power a currency suffers depends on how quickly it is transmitted into the general price level, and this can vary considerably; but eventually it is reflected in prices. So we need to consider the likelihood of an improvement in government finances sufficient to eliminate reliance on funding through the printing of money, which is the root of this evil. It is here that governments have great difficulties, which lie generally in the nature of government bureaucracy.

In government departments, there is always a complex and expensive structure designed to ensure compliance with the wishes of the executive, and to ensure that public money is properly used. This is why boxes are ticked; why it is so important to employ gender and race equality officers to ensure a department complies with government policy. The process, therefore, overrides the result, and nothing can change this. So when a government restricts public spending, there is no cut in bureaucracy; on the contrary, often more bureaucracy is required to administer the cuts and monitor the results.

The consequence is that restraint in public sector spending always feeds through disproportionately to cuts in services, leading to public outcry. And this is precisely the problem faced in Britain today. The Coalition government has adopted a hard line on public spending, following the profligacy of the previous socialist administration. This corrective approach is creating uproar, not only from users of government services and civil servants, but also from the intelligentsia who fail to properly understand the true cost of public services. So Keynesian economists are providing the public with an intellectual argument against the cuts by claiming they are recessionary, and opposition to them is growing.

What has become lost in the political debate is that at no time is the Coalition government actually cutting public spending: it is set to rise in every year of this Parliament.[i] The pain expressed so loudly in all sections of the community is solely the result of a reduction of the increase in previously planned expenditure. It is evidence that bureaucracy triumphs over services provided, and it is an illustration of the extreme difficulties politicians face in merely reducing the rate of increase of public expenditure.

These difficulties have their roots in the current situation, but a glimpse at the future also confirms government spending has to rise exponentially, with welfare and other future liabilities compounding at an alarming rate. We know that there are more pensions to provide and people are living longer, requiring increasingly expensive care services; and that all this is expected to be funded from the public purse. Less appreciated are the long-term destructive effects of inflation on private sector savings and nominal cost of providing state welfare. In other words, inflation itself has directly increased the burden on the state, and indirectly has ensured there is little private capital to fund any shortfall. Consequently, future public spending is firmly tied to an exponentially accelerating path.

In most Western democracies it is already too difficult for politicians to face up to this reality. Instead, they pursue policies conceived through hope rather than any realistic assessment of the prospects, dreaming of an economic recovery that will bring public sector borrowing back under control. This allows governments and their independent statisticians to concoct tables showing economic growth, an improvement in tax revenues, and a reduction in welfare costs as employment improves. There is no actual evidence to support this optimism.

A detailed critique showing why economic recovery is a forlorn hope is beyond the scope of this article; but if the private sector is expected to regenerate itself without savings, no sustainable recovery can possibly occur. It will also require an historical precedent: an economy increasingly under government command to actually succeed. Furthermore, governments continue to believe that all that is required is the stimulation of further bank credit, when it was excessive levels of bank credit that created the economic crisis in the first place: this is the quackery of prescribing port to cure gout. And there is very little evidence that meaningful economic recovery is developing.

The supposed economic recovery of 2010 was merely statistical, with governments using monetary inflation to puff up the numbers,[ii] and not the start of an improving economic trend. Furthermore, targeting tax increases at high earners discourages the most successful elements in society from further productive effort, and encourages them to redirect their efforts at tax avoidance instead. The consequence of these simple policy errors is to make economic recovery even more remote and reduce actual tax collected, and so spread-sheet forecasts of lower government deficits are even less likely to be achieved.

For all these reasons, we can see that socialistic government policies rely on accelerating monetary inflation. As inflation accelerates, it becomes increasingly difficult to escape the compounding effect of this exponential arithmetic.

The only way the exponential loss of purchasing power that results from monetary inflation ends is through the complete collapse of fiat currencies. Whether this is brought on by a financial crisis or through hyperinflation is irrelevant: the result is the same. Furthermore, quantitative easing programmes have merely accelerated the trend. Particularly worrying is the dramatic expansion of the monetary base in the US, which has greatly exceeded our theoretical example of 25% by increasing 168% over the last two years. While this is routinely explained as a policy response to the banking crisis, it has the likely effect of accelerating future government demand for printed money even more, speeding up its inevitable demise.

For those of us who will be victims of the collapse of paper money, there is little point in hoping that more port will somehow cure our gout: it will not. Nor can we turn to our leaders for salvation: they know not what they do. And to this rough law of the exponential trend of monetary growth we must add the abounding systemic risks present today, which we have ignored in order to simplify this analysis.

1 February 2011