|This article was written in May before the present trends to hyper inflation and scarcity of resources were so pronounced||
Simon Sheppard explores basic economics
A celebrated story exists from the German inter-war era, circa 1920-1930, when hyper inflation raged. The Reichmark had so devalued that the banknotes which comprised a worker’s pay had become too heavy to carry, so one employee took a wheelbarrow to collect his wages. Stopping on his way home to buy some vegetables, the man parked his wheelbarrow outside the shop and went inside. He emerged a few minutes later to find his wages on the pavement. A thief had stolen his wheelbarrow and left his banknotes!
Pictures exist of children during this time using bundles of banknotes as toy building bricks. The rate of increase had got so bad that customers at a restaurant would negotiate before eating, because by the end of the meal the price would have risen. Similar hyperinflation occurred more recently in Zimbabwe (formerly Rhodesia), where it became cheaper to use banknotes than toilet paper and toilet paper was almost impossible to obtain. A bus fare from work in the evening cost more than it had that morning.
Such are the effects of hyperinflation. But how does it arise? To understand this we need to recall the original definitions of the words we use, because many words have been redefined to no longer mean what they are supposed to mean. While many have heard of the hyper inflationary periods in history such as the "John Law’s days" in France and the German period quoted above, even many Economics graduates are unacquainted with the basic financial concepts detailed here.
For a start. Prices do not inflate, they increase. The original and proper definition of inflation is an expansion of the money supply. An increase in prices is just a consequence of that. An “inflation rate” (price increases) of 5% annually means that the people’s savings are worth 5% less – buy 5% less goods – at the end of the year than at the beginning. Prices have not gone up so much as the value of money has gone down. Money has been created, added to the supply and that has diluted the money already in circulation.
How is creating money even possible? Because what we commonly call money is not really money, not any more. Up until 1914, a one pound coin was called a sovereign and made of gold. British coins in circulation such as florins and half-crowns really did contain silver. Over the pound, the dollar was originally a fixed weight of silver, with silver having an established price ratio to gold. Containing precious metals, these coins were real money, with inherent value. As a last resort the coins could be melted down and used as a source of the beneficial metals that they contained.
Banknotes began as receipts for deposits of gold and silver. Nowadays what we call money is not real money at all. That is how the supply of it can be increased by simply printing it, or more usually, making an entry in a ledger. Debts and credits are created with the press of computed keys, which is only possible because we have “fiat currency”. Fiat is derived from the Latin "factum" or "thing done" which basically means that the value of the money is what the government says it is. Ultimately, the proof that it is “Money” is that the government accepts it in payment of taxes. A better word for the promissory notes that the government issues might be scrip.*
Governments cannot create gold and silver out of thin air so the temptation to employ fiat currency becomes irresistible, especially when they want to finance a war or further a particular agenda. In fact almost all of government power now derives from the ability to create “money” out of nothing. Cash to pay for foreign wars, police, prisons, propaganda and so on is effectively created out of thin air and without having to ask the tax payer to pay for it all. The power to create scrip enables the government to assume responsibilities and take powers unto itself for which it has neither mandate not legitimacy.
Governments have succumbed to the temptations of fiat currency and have run up debts so huge that they defy comprehension. Some years ago it was revealed that the interest paid on the UK national debt was £100 million per day, and the time is approaching when the tax raised will not even cover the interest on the debt. More borrowing will be required simply to service the debt. Governments are so profligate that money is bowed to give away: foreign aid.
To appreciate the enormous sums involved, consider that £500 in £50 notes is roughly 1mm thick. Then a million pound would be a pile of about 2 metres high. A trillion (1012) pounds would be two million metres or approximately 1,250 miles high. It is inconceivable that the £1 trillion UK or $10 trillion US debts would ever be repaid.
Negative interest rates turn reality upside-down in a different way: a lender pays the borrower to use his money. Such lunacy can only exist in the bizarre world of central banks and artificial currency creation. Interest rates express the amount of risk and the value of time, so a negative interest rate says: “The risk is zero and time is worth less than nothing. Negative interest rates are openly declared by the Japanese central bank and some European banks, but any interest rate that is less than the rate of price increase is effectively negative.
The creation of scrip, that is inflating the money supply, is really a hidden form of taxation. Each iteration of this process reduces the value of the notes already in circulation. Hence in the 1960s an ordinary working man could buy a house with a ten year mortgage; his wife did not need to work. Now, both man and wife must work and commit to a 25 or 30 year mortgage. While we have wondrous new amenities like mobile phones, the internet, big screens and a countless number of TV channels, our actual standard of living has dramatically fallen.
Neither is the creation of money confined to central banks. Even high street banks routinely create credit in the system know as fractional reserve banking. In this, typically 10% of a bank’s deposits are routinely held in reserve while the other 90% is issued as interest bearing loans. The 90% loaned will shortly find its way back to a bank, and that bank will typically only keep 10% in the bank. After only six iterations of this, a bank has been able to make loans of five-fold the original deposit. The only way to avoid this circular system is to borrow money from a bank and store it, for example in a mattress. The fractional reserve system relies on the depositors not all asking for their money back at the same time, which is why a bank run is so disastrous: it is not that the money is tied up in property or other illiquid assets, the secret is that the money does not exist at all.
For hundreds of years in Britain usury was forbidden by the Church. The original definition of usury is making money from money, which is what interest is. Money is not a good, it is a measure. But distorting the measure has such great advantages that the temptation to do so is overwhelming. Today practically every word of importance has had its meaning corrupted and usury is rampant. In addition to public debt there are insolvent pension funds and massive private debts such as corporate bonds. Calls, puts and all manner of derivative trades are made in a highly leveraged financial system. Around two quadrillion (1024) dollars are though to exist in derivative contracts, much of it on Deutsche Banks’ books.
The situation is unsustainable; while it is possible to create fiat currency out of thin air, it is not possible to create wealth out of thin air. Wealth so produced is as notional as the money which purchased it. Sooner or later the bill will come.
In past times the conditions which led to hyperinflation were limited to one country at a time. France, Germany, the US, Argentina and Zimbabwe have all experience financial upheaval at one time. In the present day however, the conditions which give rise to hyper inflation are occurring simultaneously all over the world. Many countries are engaged in a race to the bottom’ as they seek to exploit the advantages of creating “money” while the currency retains some value. For example, the Swiss central bank owns 5% of Apple Corp., which is achieved simply by creating Swiss Francs for that purpose.
Additionally, any significant failure could start a domino effect and cause the entire financial system to crumble. Proponents of sound money are astonished that this unsustainable state of affairs has lasted as long as it has, but there are ‘plunge protection schemes’ and all manner of manipulations taking place behind the scenes to keep the financial system limping along. Salient among these is artificially low interest rates. The normal means of arresting an inflationary spiral is to raise interest rates, as Paul Volker did the Reagan years, but the debts are now so huge that even a modest increase in interest rates would lead to mass bankruptcy.
We have been conditioned by a steady diet of Hollywood disaster films to think of the collapse as a momentous affair, following a critical event such an asteroid hitting the earth or a volcano erupting. It is certainly true that crisis can occur suddenly, but some do not feature daring heroics and dramatic adventures for a thrilling ninety-minute cinema showing. One famous wag described going bankrupt: “Slowly at first, then all of a sudden.” Financial collapse is likely to be less of an event than a process, and that process is already underway.
* Scrip a subscription receipt, is a provisional or supplementary certificate issued to existing shareholders. On the basis that we are shareholders in our nation’s wealth, the definition stands.