The standard view
An alternative view of hyperinflations
In the past, I’ve admitted to macroeconomics being one of my dark, guilty pleasures. To some “value” investors this seems like heresy, as Marty Whitman1 once wrote, “Graham and Dodd view macro factors . . . as crucial to the analysis of a corporate security. Value investors, however, believe that macro factors are irrelevant.” I am clearly a Graham and Doddite on this measure (and most others as well). I view understanding the macro backdrop (N.B. not predicting it, as Ben Graham said, “Analysis of the future should be penetrating rather than prophetic.”) as one of the core elements of risk management.
In this paper I’d like to turn to a subject that has long fascinated me: hyperinflations. My interest in hyperinflations stems not from my background as an economist, but rather from a small collection of bank notes that my father gave to me. (A peculiar benefit of his smoking habit – bank notes were used as an incentive to purchase cigarettes.) Included in this collection is a one million mark note from the Weimar Republic; it is this note that is responsible for my interest in hyperinflations. To this day I collect bank notes from hyperinflations. The notes shown in the body of this paper come from my collection2 and serve as decorative reminders of important historical hyperinflations.
My interest in these unusual events was reignited by my exposure whilst a student to the monetarist view of hyperinflation, which I found deeply unsatisfactory. This interest was then further kindled when I covered the Latin American markets in the wake of their hyperinflationary experiences.
The standard view
Ask almost anyone familiar with the subject what causes hyperinflations and at least 95% or more will trot out the stock view of economists: it is central banks printing money to finance government deficits. This view is based largely on Cagan’s 1956 paper, “The Monetary Dynamics of Hyperinflation” and/or Sargent and Wallace’s 1981 paper, “Some Unpleasant Monetarist Arithmetic.”
The quantity theory of money states MV = PY, which reads as money times velocity equals price times output. This is an identity (it must be true). In order to turn this into something more useful, some behavioural aspects or causality must be imposed. So the monetarists argue that creating lots of money (M) given a stable velocity and a stable output leads to rises in P, or inflation.
According to this quantity-theory-of-money-based view, the origins of any inflationary process are to be found in the irresponsible fiscal policies of governments. Budget deficits lead to a rise in the supply of money (by central bank printing) and consequently result in higher prices. In essence this is the result of the ability of governments to impose an inflation tax (known as seignorage), which redistributes real resources to the currency issuers.
Hyperinflation is argued to occur when the government prints too much money, causing rising prices. As prices rise, the velocity of circulation increases – no one wants to hold cash for very long if its value keeps falling. Time horizons shorten as workers demand wages at increasingly regular intervals (weekly, daily, hourly, etc.), and dash out to spend their cash as soon as they can. This means that even though the money supply is growing as rapidly as the government can crank the handle of the printing press, it can never keep up with rising prices. As prices rise, velocity rises, and so forth.3 Against this backdrop, a government will run a deficit because tax revenue can’t keep up with its spending, so it prints money to make up the gap.
The solution to an inflationary process from this perspective is to follow a path of austerity (reduce spending and/or raise revenues). This viewpoint clearly assumes that the money supply is exogenous and controlled by the central bank.
If you believe this line of argument, it is easy to see why you might well be worried about the deficits being run by countries such as the UK, the US, and Japan. Indeed, several investment banks have issued “hyperinflation” warnings over recent years, and some investors seem to regard the arrival of hyperinflation as simply a matter of time given the massive expansion of the central banks’ balance sheets.
A quick detour into false memories
To me the use of this quantity theory framework is reminiscent of the false memory problem in psychology.4 False memory refers to cases in which people remember events differently from the way they happened or, in the most dramatic cases, remember events that never happened at all. The most disturbing and tragic examples include socalled recovered or repressed memories of events such as abuse, which are “remembered” under the supervision of psychoanalysts. These repressed memories have ruined lives and yet are entirely fictional. False memories have been created in the lab as well as observed in the field.5 Researchers have shown that a week after people were told about a childhood experience in the form of a short story, 82% of the subjects made up some extra information concerning the entirely fictional event!
In fact, as this paper was making its merry way through our publication process, an exceptionally relevant new study landed on my desk.6 The abstract reads as follows:
“In the largest false memory study to date, 5,269 participants were asked about their memories for three true and one of five fabricated political events. Each fabricated event was accompanied by a photographic image purportedly depicting that event. Approximately half the participants falsely remembered that the false event happened … Political orientation appeared to influence the formation of false memories, with conservatives more likely to falsely remember seeing Barack Obama shaking hands with the president of Iran, and liberals more likely to remember George W. Bush vacationing with a baseball celebrity during the Hurricane Katrina disaster.”
It seems to me as if the standard view of hyperinflations is akin to a false memory. We have all heard that “central banks printing money leads to hyperinflations” so often that it must just be true. It is a simple, short narrative – exactly the kind that produces false memories.
1 Martin J. Whitman, Value Investing: A Balanced Approach, John Wiley & Sons, 1999.
2 With the exception of Georgia’s coupon, which has yet to find its way into my collection. The note you see on page 9, alas, was downloaded from the internet.
3 To make the quantity theory fit the hyperinflation scenario, Cagan basically had to abandon the “normal” assumption of a stable velocity of circulation.
4 Elizabeth F. Loftus, “Creating False Memories,” Scientific American, 1997.
5 Maryanne Garry and Kimberley A. Wade, “Actually, a Picture Is Worth Less Than 45 Words: Narratives Produce more False Memories Than Photographs Do,” Psychonomic Bulletin & Review,12 (2), 359-366, 2005.
6 Steven J. Frenda, Eric D. Knowles, William Saletan, and Elizabeth F. Loftus, “False Memories of Fabricated Political Events,” Journal of Experimental Social Psychology, Vol. 49, Issue 2, March 2013.