Hyperinflation and Institutions

Early on during the 2007–09 financial crisis, after the Fed committed to its unconventional asset purchase program (the first round of quantitative easing), several people — pundits and economists alike — predicted hyperinflation. For the most part, these predictions have been discredited: not only has there not been hyperinflation, but “core” inflation remains relatively low. My intention isn’t to again entertain the possibility of hyperinflation, but I’m interested in the answer to the following question: is hyperinflation meaningfully possible in the United States, and other economies with similar institutional qualities?

In This Time is Different, Reinhart and Rogoff use the term “graduation” frequently. What it refers to is the idea for an economy to “graduate” itself from certain classes of crises, or develop to a point where certain types of crises are no longer as likely to occur. For example, oft-repeated examples throughout the book are Spain and France, which “graduated” from debt crises after the 19th century (well, with regards to Spain, we’ll have to see if it relapses). They note that no country has “graduated” from financial crises. I wonder, though, if it’s possible to tentatively “graduate” from hyperinflationary episodes. Further, I wonder if the United States is an example of such graduation.

What brings me to this is some thought I’ve put into the question of the U.S. national debt, its projected size, the projected size of gross domestic product, and the degree of fiscal consolidation that the U.S. would ideally need to go through in order to guarantee some given “fiscal space” in case of a major financial crisis in the future. While I haven’t really done the work, including coming up with some numbers, it seems to me that sovereign default is becoming more probable over time. That is, unless the U.S. makes a habit of running surpluses during boom years, the government’s “fiscal space” will diminish over time, to the point that a major crisis may push the country’s finances over the edge, so to speak.

Putting that aside, and assuming its truth (for the sake of argument), which do you see as a more likely outcome?

  1. Technical default through inflation;
  2. Debt restructuring.

The reason I ask is because hyperinflation is associated more with (1) than with (2). Hyperinflations tend to occur in countries where government expenditure is mostly financed through the printing press, and these governments also tend to have issued large amounts of sovereign debt (that is, printing presses are resorted to when capital markets dry up). I’d say that (2) is associated more with monetary and output contractions, and the devaluation of safe assets (sovereign debt), which in turn can cause or exacerbate financial crises.

In the case of the United States, I’d think that (2) is the most likely route. First, there is a general culture which penalizes fiscal excesses and imputes on the mind the notion that spending through inflation is undesirable. Second, the Fed is independent, and is likely to remain independent (this can also feed on the first consideration). Fed independence implies a misalignment of intentions between politicians and those responsible for monetary policy. Third, there is always a large number of politicians, pundits, and ideologues who advocate fiscal conservatism, meaning that there is bound to be political support for debt restructuring over alternative forms of debt default. More generally, the United States has political institutions that rewards certain outcomes over others.

Given these institutions, can we make the claim that the U.S. has “graduated” hyperinflation? To be clear, graduation doesn’t imply that economies cannot devolve, or worsen in quality — there are, in fact, several examples throughout history of just this occurring. Further, it doesn’t imply that alternative forms of governance aren’t better. The question really is: have some countries, like the U.S., outgrown hyperinflation? I think there is a strong case to argue ‘yes.’

Tangentially, I don’t know the literature on hyperinflation very well, but to what degree does hyperinflation depend on expectations? Hyperinflation requires the expectation that the money supply will continue to grow at an accelerating pace, meaning that the issuer’s credibility is essentially nil. Is it possible for an independent Fed — or, at least one short of monetizing government debt and funding expenditures — to “achieve” such low levels of credibility? It’s difficult for me to think of a legitimate program, even within the range of the “unconventional” (such as large scale non-treasury asset purchases), that would result in infinitely elastic expectations. This is why when I talk about hyperinflation I consider political institutions, rather than monetary institutions in particular, most relevant.

12 thoughts on “Hyperinflation and Institutions

  1. Robert M.

    Well, you certainly have a point about this “general culture” penalizing excesses, but isn’t debt restructuring just a mild form of default? As I see it, it’s just a default under a different moniker and, as such, involves reputation issues. Of course, reputation is not the only variable government takes into account, but given that U.S. is still the biggest economy in the world, operating the reserve currency and being a point of reference for policymakers in basically every country, its debt restructuring could have a great destabilizing effect on the world economy, with a possible outcome of other countries judging the U.S. reputation as discredited and seeking, e.g., other currencies etc. That’s why I give quite a serious thought to the possibility of rapidly growing inflation. My intuition is that rising inflation can be for some time more easily concealed as something not directly related to policy – in other words, it’s easier to fool the general public about inflation than debt restructuring, thus not damaging, at least in the short run, country’s reputation – and that’s why I think it may be considered an option by the government. Indeed, there’s a considerable historical record (analyzed also by Reinhart & Rogoff, if I remember correctly) of governments doing just that.

    As of your question about hyperinflation and expectations, I’m not familiar with any specific literature on the subject, but I guess that the mainstream approach is still connected with Cagan’s model, which of sees hyperinflation as extremely closely related to expectations.

    1. JCatalan

      Right, debt restructuring is a form of default — that’s why I presented it as an alternative to seigniorage in the event of reaching the limits to our “fiscal space.” I also agree that debt restructuring, or any form of default, will reduce a government’s credibility. But, we’re talking about two different credibilities, as long as money is being issued by a technically separate institution (like the Federal Reserve). In one case we’re talking about credibility as a borrower (capital markets may be relatively more closed to a country with a lower credibility as a debtor), but in the other case we’re talking about credibility as a money issuer — that is, the credibility that you will maintain the relative stability of a currency.

      Further, you’re right that debt restructuring is bound to lead to a fall in output. As I wrote in the post, these kinds of defaults should be associated with output contractions. But, I also suggested that it would lead to monetary contractions. We should consider separately the contractionary effect of a technical debt default and any countercyclical policy that either the government or the central bank will commit to. Finally, a central bank might commit to countercyclical monetary policy, but this is different from outright debt monetization. It may lead to inflation, such as what we have currently, but I don’t think it could ever lead to hyperinflation.

  2. Roman P.

    Hyperinflation probably requires a collapse of industry and social institutions, with sharp reductions in production and the demand for money (US dollar). Not likely.
    USA debt restructuring will be akin to shooting yourself in the head for no particularly good reason, but, you know. I could see you Americans doing something like that.

    1. JCatalan

      Regarding output contractions, like I said, I haven’t really read the literature, but I wouldn’t be surprised if severe output contractions occur almost simultaneously (both as a result of rapid money expansion and making necessary further money expansion). But yes, hyperinflations are associated with severe output contractions (who’s going to produce if you can’t predict the value of future income?).

      To be clear, I don’t think the U.S. is going to restructure its debt during this recession. I think it has plenty of “fiscal space.” But, financial crises will occur again, and if the level of government debt continues to rise (even assuming an increase in tax revenues during boom years, recession years will still be associated with collapsed revenue streams) then the amount of “fiscal space” available in the future will be much more restricted, making technical debt default more likely as long as the size of the national debt continues to grow (although, it also depends on the rate of GDP growth). In any case, think of this as a hypothetical in order to consider whether hyperinflation is even possible in economies with certain political institutions.

      1. Roman P.

        Hyperinflations, as we know them, probably require a very special model that is explicitly in disequilibrium: demand for the goods rises, demand for the money falls, supply of the goods contracts in a positive feedback loop. But, looking at the historical cases, it seems that a massive supply shock must come first.

        I find the very notion of ‘fiscal space’ problematic. Is it 200% GDP? 400? 1000? I don’t think that there exists an explicit constraint on how much public debt there could be, but the subjective constraints are another matter. I won’t be surprised if the rulers of America will enter a state of panic in future and decide that they are on the brink of the disaster and that they need to essentially declare USA bankrupt right effing now, with easily foreseeable consequences. I remember when GOP had USA in a pretty tight spot last year, when it almost blocked the rising of the debt ceiling, so I think this is realistic.

        P.S. Though, I could imagine an interesting possibility for the collapse of the USA. Because the government debt redistributes the wealth to the wealthiest, the inequality will continue to grow, depressing the demand (in a Kaleckian fashion?), this in turn deepening the recession, this increasing inequality even more, the overall process accelerating… But it is very, very far-fetched scenario.

        1. JCatalan

          Fiscal space does depend on the country in question; different countries have different levels of debt tolerance. But, I’d say that objective factors that decide fiscal space include investors’ confidence (which may be manifested through interest rates), the pace of output change, and debt sustainability.

        2. Stadius

          … because the government debt redistributes the wealth to the wealthiest, the inequality will continue to grow, depressing the demand (in a Kaleckian fashion?), this in turn deepening the recession, this increasing inequality even more, the overall process accelerating… But it is very, very far-fetched scenario.

          Far-fetched? I’d say this has been happening for the past 30-40 years, but I’d add that the growing government debt (and household debt) was necessary in the first place to prevent a realisation crisis from a falling wage share. In other words, the crisis looming in the 1970s wasn’t resolved by the likes of Thatcher or Reagan as per the usual narrative, it was merely postponed until circa 2008.

          1. Jonathan Finegold Post author

            Stiglitz makes a similar argument in The Price of Inequality, but I’m not too convinced. I do think it’s related to economic instability, but I think it’s a symptom rather than the cause.

  3. Silvano

    Basically, the debt held by the Fed don’t need to be funded – at least until the Fed keeps it in its book, but do you know how big is its size?

    1. JCatalan

      Well, there’s a difference between assets held by the Federal Reserve and Federal debt (the Fed [Federal Reserve] holds large amounts of Federal debt).


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