Inflation and Monetary Regimes
“Inflation presupposes the existence of money, which evolved as an unplanned social institution by a number of inventions and innovations during a period of perhaps 2500 years . . . It follows that inflation cannot be older than money. But if seems that especially rulers soon detected the potential to increase their revenues by tampering with its value . . . The damage and suffering caused by inflation during the course of history are enormous. Still, the worst excesses of inflation occurred only in the 20th century. This development was a consequence of the further technical development of money from coins to paper money and book money together with changes in the monetary regime or constitution ruling supply and control of money.”
– Peter Bernholz, “Monetary Regimes and Inflation”
Peter Bernholz is the Professor Emeritus of Economics in the Center for Economics and Business at the University of Basle, Switzerland. His 2003 book, Monetary Regimes and Inflation, serves as a comprehensive guide to historical inflationary episodes and the influence of both political administrations and monetary regimes in fostering them. Professor Bernstein analyses the 29 known hyperinflations dating back to the Roman currency debasement in the fourth century and concludes that deficits in excess of 40% of expenditures, significantly raise the risk of hyperinflation. While most of the world is focused on the current fiscal difficulties across the Eurozone today, we would note that our own government has recently entered into the Bernholz Warning Track with a 42% ratio of deficit to expenditures at our last count. Importantly, we do not interpret this as a sign of an immediate inflation on the horizon, as our own work points to heightened levels of deflation in the intermediate term, primarily due to the impact of ongoing private sector deleveraging on the money multiplier. We’d also encourage investors not to lose sight of the collapse in M3, which has no precedent since the Great Depression, despite the fact that Mr. Bernanke no longer pays attention to the series, deeming it too erratic to be of much use.
But, we digress. Irrespective of our own views, it is critical for investors to understand what is coming down the pipe and position portfolios accordingly. Wayne Gretzky once explained, “I skate to where the puck is going to be, not where it has been.” In this light, we’d suggest that as household balance sheets are repaired over time, the effects of unprecedented monetary stimulus, debt monetization and currency debasement will almost certainly be felt through a striking return of inflation later in the decade. So in an effort to determine “where the puck is going to be,” we’ll be spending some time in coming weeks reviewing Bernholz’s Monetary Regimes and Inflation. Let’s begin with some history to better understand the conditions in place today:
The price levels in the US, UK, France and Switzerland do not exhibit a trend until 1914. Professor Bernholz reckons that the change from a non-inflationary to an inflationary environment can be explained by the change of monetary regime post 1914. Under Metallic Standards, like the gold, silver or copper standards, the amount of money in the system is regulated by the supply of gold, silver or copper. Since the quantity of these metals is limited, structural inflation can only occur if new deposits are discovered and inflation is still limited by the additional supply brought into circulation. But after World War I, several countries moved toward a Weakened Metallic Standard, weakening further with the advent or Bretton Woods after World War II. Discretionary Paper Money Standards have no natural limit for the expansion of the money supply. The issue then, as described by German Professor of Economics, Adolph Wagner in 1868, is that “Men would first have to be capable of unlimited self-discipline to resist any temptation to increase money arbitrarily, even if their very existence, or that of the state, were at stake.” If nothing else, recent history promises that today’s “men” do not have this discipline. When faced with the decision to let the economy naturally (painfully) adjust or print, the printing press is man’s best shot at re-election. It is no, coincidence then, that all hyperinflations in history (with one exception) have occurred after 1914, under Discretionary Paper Money Standards.
Professor Bernholz concludes that the tendency of currencies towards inflation depends on the monetary regime. Paper money standards with “independent” central banks (we struggle to think of any) are less inflation-biased than those with dependent central banks. On a side note, we find it curious that the US stock market has not experienced a material loss in the third year of an election cycle since 1929. Yet, we are to believe that the US Federal Reserve is “independent.” Coincidentally, stimulus at the right time tends to stimulate the economy, reduce unemployment, and improve re-election chances. But inflation follows with a lag after the election, and measures taken to reduce inflation have negative follow-on effects on economic activity and employment. Consequently, inflation pressures must be contained in time to allow for a new stimulation of the economy before the next election! A vicious cycle indeed. A cycle responsible for the inflationary bias of democratic governments, according to Bernholz. More recently, David Einhorn expressed similar views at the recent Ira W. Sohn Investment Research Conference:
“Politicians value staying in office more than they value the long-term health of the country. Spending money in the short-term buys votes. It’s not good politics to take on the obvious long-term insolvency of popular programs that transfer wealth from the young to the old. The elderly reliably show up on Election Day. Children have no voice at the polls. The AARP is an extremely powerful interest group. There is no similar organization lobbying on behalf of ten year olds.”
Importantly, the positive impact of an expansionary monetary policy is short-lived. But Bernholz correctly suggests that voter’s “rational ignorance” will judge the performance of government on these former policies where results are targeted to particular segments of the population and costs are spread widely so as not to be felt. The convenience of such a strategy is that expenditures can be increased without burdening anybody. Sure, we will have to pay back the mounting debt, but that is a problem for the next generation, the next administration, and after the next elections.
It is obvious from the above commentary that the temptation for inflationary deficit financing are highest during periods of slow, or no, economic growth. We suggest anyone questioning this argument, keep a close eye on Europe, and the ECB’s recent change of heart on the subject of debt monetization. Critically, Bernholz concludes that a hyperinflation has never occurred throughout history, which was not driven by a huge budget deficit of the state.
With this in mind, we’ll conclude our initial look at Monetary Regimes and Inflation with a quick peek at the state of fiscal balance sheets, as recently published by the Economist: