Guest Post: The Mathematics Of Hyper-Inflation

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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


 





[ii]

GDP numbers are deflated by a measure of cost
inflation, while monetary inflation is
considerably greater. The Increasing monetary
input has the effect of raising nominal GDP
artificially.

See

http://www.financeandeconomics.org/Articles%20archive/2011.01.12%20USDGP.htm