# Monetary Regimes and Inflation Author: [[Peter Bernholz]] ## Review The book examines the causes and process of inflation, and in particular hyperinflation. Its conclusions provide a good counter to the policy ideas that are emerging from the growing popularity of MMT. The inflationary tendency of a currency depends on the monetary system. There are three possible monetary systems: 1. **Metallic standard** When the currency is tied to the value of metals and banknotes are fully convertible. Anyone can melt down and mint new currency and this keeps the value in check. It also creates fixed exchange rates between different currencies. 2. **Weak metallic standard** The currency notes are partially convertible, such as the Bretton Woods system after World War 2. Only central banks could exchange dollars into gold. All countries were on a paper standard with a fixed exchange rate to the US dollar. This ended in 1971. 3. **Discretionary paper standard** Here the currency cannot be converted into anything. There can either be a fixed or floating exchange rate system, with differing implications for monetary policy. The inflationary tendencies of monetary systems are created by politicians. The only way to prevent it is to bind the hands of politicians. Metallic standards are the least inflationary, or have experienced the lowest inflations, followed by systems centered on independent central banks. Hyperinflations have only occured after 1914, except for the French Revolution (which saw the introduction of the assignat). There were some other cases of high inflations such as the american war of independence, and the American Civil War. Both of these were based on a paper money standard. There was also the case of the roman currency debasement in the fourth century, and the recurring inflations of successive chinese dynasties which started by issuing banknotes and ended with inflation because they issued currency to finance deficits. His main thesis is that high inflations are caused by budget deficits financed through money creation. He is not completely rigid on this point and also admits that high inflations make budget deficits worse. It cannot be said for certain that one causes the other. Especially since one of the episodes of hyperinflation (Yugoslavia) did not have a budget deficit. He describes the process through which high inflation happens and also creates a model for it. One of my criticisms of the book is that the ideas are not laid out in an order or structure that makes it easy to consume. I have modified his model and description for my own sake here, and some of these periods overlap: 1. Paper money is first introduced and preferred by people because it is easier to use. It reduces the friction and transaction costs of an economy. 2. Governments take on debt to support the economy. With time, the interest on debt consumes a higher share of revenue and leads to higher rates in markets, and even crowds out other investments. The government becomes tempted to finance the debt with new money. This prevents higher rates in the short term, and creates positive effects. But over the long term it creates inflation. Almost all episodes of hyperinflation are associated with budget deficits, with some rare exceptions. 3. The currency being depreciated or debased drives good money out of circulation. Here good money is either metallic currency or foreign currency or a currency of the same country but with different parity/rules/laws. Through this period there is a loss of official reserves. 4. At this stage the existing parity or fixed exchange rates have to be broken. 5. Government goes through great lengths to maintain the use of the currency and to prevent people from protecting themselves from inflation or from bypassing the use of the depreciating currency 6. People start to use foreign currency or hard money for transactions, and the good money drives out the bad money. The hyperinflation also makes the political conditions for monetary reform possible which would introduce good money. For monetary reform to be successful the public needs confidence in the currency and for government finances to be in order. Some of the conditions leading up to past periods of hyperinflations could just as well have been describing what we are seeing today. This section in particular stood out: >_it has still to be explained why the money supply rises more than the productive potential of a country…As has been argued, the party in power may introduce an expansionary policy to stimulate the economy and to lower unemployment exactly in time to increase their chances of winning the next election…**Given a supply shock, the government may be tempted to increase the money supply to counter some of the negative consequences**. Though it cannot reach this goal in the end, at least the situation  may be better at election time, since the rise of price level follows only later…_ > > _We this have to ask ourselves, **which political forces are powerful enough to increase a budget deficit to such a level that money creation seems to be necessary to finance it,** and this in such a magnitude that high and hyperinflation result? Historically, three different chains of causation seem to have led to such developments…A second possibility is a strong push, for instance **if a new populist government speedily increases minimum wages or all wages by a high percentage and similarly public spending**. In most such cases, moreover, controls setting maximum prices are introduced by governments…_ > > _It Should already be obvious that such policies could **and can only be introduced in already weak or weakening political systems**, in which parties or rulers are in desperate need to use extreme measures to gain or maintain popularity or power, **in which knowledge of existing economic realities is very weak or non-existent , or in which utopian ideologies are believed and win the upper hand.**_ There are a few things that need to be looked at to improve this model, such as the difference between different types of money. By this model Japan should have been a prime candidate for hyperinflation, except for the magnitude of the deficit. There were many voices calling for hyperinflation in the aftermath of the GFC, who turned out to be incredibly wrong. One of the problems is probably not differentiating between types of money (reserves vs spendable cash). I find it incredibly ironic that the risk of hyperinflation is laughed at now, even though the political, monetary and economic conditions are eerily similar to previous episodes. Not only are we laughing in the face of this risk, we are constructing an entire policy around the denial of its causes. I am going to continue researching past periods of hyperinflation and its causes to get a better understanding and intuition for the process. Ultimately its important for me to estimate how likely it is that this could happen and, if it does, what to do about it. The next book in that respect will be [[Hyperinflation - A World History]] by [[He Liping]]. ## Misc. Book Notes - inflation is a monetary phenomenon, when the money supply exceeds the productive capacity. It's not that simple though. It can also happen when a currency is substituted for another and that base of money is used for fewer and fewer transactions. As an inflation starts to pick up, the currency is replaced for another, as people look to get rid of their holdings of it. This exacerbates the inflation measured in that currency. - King Philip II preferred bankruptcies over debasement of the currency because the value received from minting the currency used in international trade was so valuable. - the biggest inflation that occurred on a metallic monetary system is that of the Roman Empire in the 4th century AD, from 324-341. - The first paper currencies were introduced in China before 1000AD, and in Europe by Sweden during the 17th century. They were first convertible into specie. - Nearly every chinese dynasty up to the Ming dynasty began by issuing convertible paper money and ended with pronounced inflation by creating more money to finance government deficits. - Governments will go to great lengths to prevent the devaluation of a currency but it doesn't work. There are a few great examples in the book of what happens to people when they try to protect themselves from inflation or bypass the depreciation currency. - at the start of inflations there is always a rise in economic activity. - Credit and Capital markets shrink during high inflations. The real economy shrinks and the real relative factor prices become volatile. - Inflation variability also increases with increasing inflation. - wages for unskilled workers do not lag much behind inflation, but for skilled workers they do, and even more so for high ranking employees. - the only way to prevent currency debasement is to bind the hands of government in some way. #### Parts I liked - There are a number of vignettes describing the inflationary experience by people who were there. These are from the perspective of various authors, conversations the author had with people, or from the authors own experience. I loved these and created a very vivid picture of inflation, in particular high inflations. - The connection between political system and monetary system, and inflation was very interesting. The demands put on the government and their ability to weaken the monetary constitution causes the inflation. #### What I didn't like - Skipped the formulaic parts of the model. It is easier to understand the description of the model in plain English. - There is something psychological about hyperinflations, like a bubble, or inverse bubble driven by the spread of beliefs about the value of the currency. This likely makes the inflation worse than is suggested by the fundamentals (how much money there is compared to the size of the economy/transactions). - The author does not discuss the japanese experince of recent decades. I think this shows we need to differentiate between different types of money. Or maybe where the money ends up. ## Related - [[How Inflation Works]] - [[Money]] - [[Economic Theories]] - [[Financial Crises]] - [[Hyperinflations and Political Crises]] - [[Currency Reforms]]