The Introduction of Paper Money

Before moving onto the Characteristics of Hyperinflations, Bernholz introduces the concept of Moderate Paper Money Inflations.  A few basic conclusions are made here which we’ve summarized below:

  • During inflation, an undervaluation of paper money develops compared to gold, silver or copper. It’s difficult for us to argue with this point, except that we’d caution investors not to assume that rising gold prices necessitates a coming inflation.  Precious metals are rising against all paper currencies today.  We view this as more of a sign of mistrust for the developed world’s reckless fiscal and monetary policies.

  • An increase in the money supply first stimulates economic activity, whereas price increases lag.  On the other hand, if the rate of growth of the money is substantially diminished or even becomes negative, then depressive consequences are felt before the price level recedes. We’d ask that all the Inflationistas out there re-read that last sentence, which appears to be completely lost by Milton Friedman and Company who focus solely on the supply of money with no respect for the multiplier.  With that said, we’ll reproduce an important chart from our last post, which should be somewhat of a recurring nightmare for our Federal Reserve Chairman, except that he no longer pays attention to what he does not want to see.


  • The developments just sketched lead to political reactions which may even strengthen or bring about sequences of events. Hmmmmm.
  • If a moderate inflation turns into a high inflation, economic activity is adversely affected. This minor detail appears to be lost on our policymakers who are determined to create “just the right amount” of inflation to offset the economy’s post-crisis, deflationary tendencies and avoid Great Depression 2.0.  Needless to say, we have our doubts.  Bernanke is so set on not repeating the mistakes of 1937-1938 – when the punch bowl was removed too soon – that it is almost a near certainty that he will err on the “too late, too long” side of the inflation coin.  Will give handsome odds, to anyone willing to take the other side of that bet.
  • Wage increases usually lag behind the rise of the price level. Translation for tomorrow’s domestic economy: Structurally high unemployment and declining real wages.  Ruh Roh!

  • Currency substitution plays an important role if inflation is progressing and the fixed exchange rate can no longer be maintained.  Finally, the bad money will be driven out of circulation, and the unstable money becomes worthless.

Bernholz concludes by constructing a picture of a full inflationary cycle.  First, paper money with no intrinsic value is introduced – initially convertible at a fixed rate of course.  These notes are a welcome addition at first as they are not as heavy and easier to store and transport than gold bars.  But with more and more paper money, convertibility becomes difficult since official reserves dwindle (just ask Roosevelt), and ultimately, convertibility can no longer be expected.

We’ll be spending the next few weeks reviewing the meat of Monetary Regimes and Inflation – Characteristics of Hyperinflations.  One lovely trait is that people try to spend their money as quickly as possible, since they expect that it will soon lose its value by future inflation.  As a consequence, prices rise more quickly than the supply of the paper money and the real stock of money decreases.  Lovely.

Disclosure: At the time of publication, the author was long Gold and long MarketVectors Gold Miners ETF, although positions may change at any time