The Short Happy Life of Fiat Currency

Inflation has all but destroyed paper currency over the last century – the dollar lost 95% of its value. But slow and steady has not been the rule, argues Christopher Mayer; hyperinflation is "not so rare." Could it happen to the dollar?

"We inflate our paper currency, we repair commerce with unlimited credit, and are presently visited with unlimited bankruptcy."

– R.W. Emerson, The Young American, 1844

According to the Chambers Dictionary of Etymology, the quotation above was the first appearance in English of the verb inflate – meaning an increase in currency. If only Emerson could see now what inflating has wrought.

In the pages of a book titled "Triumph of the Optimists: 101 Years of Global Investment Returns" there is a spread of telling graphs conveying the inflationary damage done to the world’s currencies. Here we can see that not only the dollar, but also all paper currencies, are engaged in a race to the bottom.

Hyperinflation: A Uniquely 20th Century Problem

Monetary inflation is uniquely a 20th century problem that continues to the present day. Prior to that, monetary systems, such as they were, consisted of commodity-backed money. Inflation, then, was most often a product of temporary suspensions of the commodity standard, usually occurring during wars or panics.

At times, inflation also occurred as the supply of gold and silver grew. There were spikes in some countries and regions during certain periods of time when the supply of gold jumped due to discoveries and such (in California during the gold rush, for example). But, by and large, a dollar in 1900 had held its purchasing power with the dollar of 1800.

The 20th century American had a vastly different experience. As the "Triumph" authors note, "A dollar bill put under the mattress 101 years ago would today have only 4.2 percent of its 1900 purchasing power, that is, four cents in 1900 had the same purchasing power as $1 in 2000." Said another way – that’s a loss of 95%.

Furthermore, the pace of price increases was much greater in the period subsequent to 1970, where, as "Triumph" notes, annual prices rose at a 5.1% clip compared to 2.4% for the first seventy years of the century.

Hyperinflation: The Third Best Performing Currency in the World

What is particularly scary about the dollar is that it has been the third-best-performing currency in the world. Only the Swiss franc and the Dutch guilder (by a very small margin) have held up better. In the UK, for example, the rate of price increases over the same full 101-year period was 4.2%, compared to the 3.2% in the U.S. – a seemingly small difference. And yet, compounded over time, U.K. prices increased 55-fold, a factor more than 2 times that of the U.S.!

In a line graph found on page 92, the authors show us a spread of sixteen currencies, plotted in terms of nominal exchange rates against the U.S. dollar. Because of the German hyperinflation in the early 1920s, the German mark just falls off the graph, literally becoming worthless. The other currencies turn in visibly worse performances than the dollar, with the aforementioned exceptions of the Swiss franc and Dutch guilder.

Keep in mind, as I pointed out earlier, the dollar has lost 95% of its purchasing power…and yet, it still beats almost all of its rivals, sometimes by very large margins. The performance of fiat currencies in the past century has been dreadful.

But what has changed? If anything, the monetary setting of today is worse than that of the 20th century, for at least in the earlier part of that century there was still a gold standard. Really, up until 1971, there was some semblance, however weak, of an international gold standard.

The monetary shackles on today’s central bankers are, I would argue, much more lenient. Hence, the threat of inflation is far more lethal. As horrid a performance as the dollar turned in for the 20th century, the 21st might make it look pretty good.

Paper monetary systems have a tendency to blow up, in what is commonly called a hyperinflation. They are really not so rare, looking again at the 20th-century experience, as one might suppose. Yes, there is the famous German hyperinflation of 1922-23, where price inflation was 3,422% in 1922 alone (and where, in January 1923, one could buy a dollar for 20,000 marks – but by early November it took 630 billion marks to buy that same dollar). The numbers are simply staggering and hard to comprehend. Yet, Hungary’s hyperinflation of 1945-46 was even more spectacular, with price inflation of 19,800% per month.

Hyperinflation: Updating Phillip Cagan

Phillip Cagan wrote, in the 1950s, what many consider to be a classic study of hyperinflation, in which he set the definition of the term at an arbitrary price inflation rate exceeding 50% per month. Even so, Cagan finds seven hyperinflations meeting his definition, the limiting factor being that these seven were the only ones where monthly price data was available. They include the great German hyperinflation, two in Hungary and also hyperinflations in Austria, Greece, Poland and Russia. These all occurred between 1921 and 1946. Witness, then, that the phenomenon was not a rare thing.

To update Cagan, I hunted around for some more recent hyperinflations. There were many, mostly in emerging markets. A recent essay by a pair of IMF researchers (Carmen Reinhart and Miguel Savastano, "The Realities of Modern Hyperinflation") revealed a bunch more, occurring in places like Argentina, Bolivia, Brazil, Peru and the Ukraine. And they don’t cover them all. Further searching provided examples of devastating hyperinflations in Zimbabwe, Zaire, Georgia and Nicaragua. I suspect there are many more.

The most interesting part of the IMF researchers’ essay was their conclusion. They wrote: "The benign inflation environment of recent years may lead some to believe that chronic high inflation and hyperinflation have been eradicated for good. History suggests that such a conclusion is not warranted."

Indeed, that is precisely the point. Do not be deceived by recent experience. Structurally, all the pieces are in place to experience very high levels of price inflation.

Crystal ball gazing on monetary systems is extraordinarily difficult, of course. There are lots of things that can happen along the way. It was not that long ago – 1996, to be exact – that economist Steven Hanke wrote a piece titled "Argentina, the ‘Germany’ of South America." He meant the Germany of the post-WWII era, where the sturdy mark proved to be one of the world’s most stable currencies. His case rested mainly on the passage of tougher laws and a currency board-like system.

This prediction, of course, proved very far off the mark, since the Argentina of today is recovering after its most recent financial meltdown. Far from being the Germany Hanke envisioned, it became more like the Germany of the 1920s.

This is not to say hyperinflation is imminent or even likely in the U.S., but it points to the dangers of men with printing presses. And it points to the weakness of the dollar – or any paper currency – as a long-term investment.


Christopher Mayer,
for The Daily Reckoning
March 18, 2004

Editor’s note: Christopher W. Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Christopher’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is also the author of "Capital and Crisis," a recently launched investment advisory for contrarian-minded financial observers.

You will remember that we took two important guesses in the last few weeks. We guessed that the world might have seen $400 gold for the last time in our lives. And we guessed – just this week – that the bear market rally of 2002-2004 has finally rolled over. In both cases, we hedged our bets with the saving grace: ‘we think.’

We were happy with our guesses. But even happier with our hedges. For hardly had our fingers left the keyboard than gold dropped below $400…down as low as $395. Now, it is back well above $400, as it should be. But we retain our ‘we think’ preface to ‘it should stay above $400,’ just in case.

Yesterday, the Dow bounced back…and most of the news was upbeat…if not delusional.

"Refinancing demand soars 40%," says CNN. Mortgage applications increased 25% last week. And from around the country come signs that the housing boom is not entirely over. Arizona reports homes sales hitting records. From Orange County, CA, comes news of a 23% increase in house prices last year.

Still, we note that the major stock market averages all seem to have topped out between January and March…just as they did 4 years ago in the U.S. and 14 years ago in Japan. We think, we add with our fingers crossed, the rally is over.

Oil rose to its highest level in 13 years yesterday. The dollar fell again. Credit is still plentiful, but jobs are scarce.

Should we actually hope for a continuation of the bear market, readers might ask themselves? Would we enjoy watching our countrymen get wiped out in the stock market? Would we chuckle with schadenfreude as millions of lumps went upside down…owing more on their houses and cars than they were worth?

Well…yes…it is only money…and it is such a grand comedy!

Besides, what kind of heartless brute would want to see Americans continue to ruin themselves? On the advice of Alan "Bubbles" Greenspan, the poor lumps go further and further into debt, digging a deeper and deeper grave for their money. They refinance their houses to buy what they cannot afford and do not need – and count on Alan "Bubbles" Greenspan to pull the right levers and turn the right knobs so they will never have to pay for their mistakes.

Day by day, the entire Lumpen Nation loses its jobs, its skills, its capital…and risks losing its soul…to E-Z credit. The Feds add $2 billion to the national debt every day. Five hundred billion per year is the net cost of America’s trade deficit. Ben Bernanke at the central bank pledges to keep short-term lending rates as low as necessary, as long as necessary…to make sure the borrowing binge continues.

The sooner it is over, the better. So cheer up, dear reader. The end is coming…we think.

In the meantime, and in-between time, here’s our correspondent in New York, Eric Fry, with more of what is, like, happening…


Eric Fry from the heart of Wall Street…

– While Manhattan’s St. Patrick’s Day Parade trudged up 5th Avenue yesterday through the snow and sleet, a little "luck of the Irish" rubbed off on Wall Street. The Dow Jones Industrial Average jumped 116 points to 10,300 and the Nasdaq Composite surged 33 points to 1,977.

– "The triple-digit move in the Dow has become old hat of late," notes CBS Marketwatch, "as the blue-chip barometer has closed with either a gain or loss of 100 points or more in four of the last five trading sessions."

– Stock-buyers did not seem especially perturbed by news that inflation is ticking up slightly; nor were they overly troubled by the news that terrorism is ticking up significantly…Less than one week after the deadly Madrid bombings, another terrorist bomb exploded in Baghdad’s Jabal Lebanon Hotel, killing at least 27 people.

– When news of the bombing crossed the wires shortly after noontime in New York, the Dow dipped briefly. But the lumpeninvestoriat stepped in quickly and aggressively, bidding the market higher throughout the rest of the day. The gold market responded more visibly to the grim news – surging $5.00 to $407.25 an ounce. That’s the safe-haven metal’s highest closing price in a month. Perhaps the firming gold price is also a reaction to an inflationary trend that the Consumer Price Index fails to recognize. According to the Labor Department, the CPI rose 0.3% in February, which means that consumer prices have increased only 1.2% year-over-year.

– But for those of us who eat food, heat our homes and drive cars, the real-world inflation rate seems somewhat higher…Even within the government’s own misleading CPI report, some signs of inflation are evident.

– Energy prices jumped 1.7% in February, for example, while "core" goods prices increased 0.2 percent, the first rise in 18 months. And of course, medical costs continued rising in February at twice the overall inflation rate. Meanwhile, unofficial signs of a budding inflation are as plentiful as acne on a teenager. Oil gushed yesterday to a new one-year high above $38 a barrel, while gasoline prices neared a new all-time high.

– Refineries are running full-out to keep pace with demand, but gasoline prices are climbing anyway. The nation’s oil refineries operated at 90.5% of capacity in February – "only a fraction of a percent below the all-time high for February utilization set in 1998," the API says. Maybe expensive gasoline is not the same thing as inflation itself, but that fact does not make filling up your car any less painful.

– Meanwhile, mortgage applications are also "inflating." Last week, mortgage applications jumped to their highest level since July 2003, according to a survey by the Mortgage Bankers Association of America. The group’s mortgage loan applications index soared 25.6% in the week ended March 12, as the number of mortgage applications for refinancing rocketed 39.7%. Some of this easy money, we assume, will make its way into shopping malls and auto dealerships – boosting consumer spending yet again. Expect the consumer to continue spending other people’s money throughout the second quarter…at least.

– What should we make of gold’s recent resurgence? The yellow metal has gained $12 over the last three trading sessions. "Gold prices are poised to push above $425 very soon," says Kevin Kerr, editor of Kwest Market Edge. "Gold is a safe haven…and [with] the ever-present and growing fear of terrorism at home and abroad, many investors are sleeping better with a few gold bricks under their proverbial pillow."

– According to Kerr, Spain’s decision to withdraw its troops from Iraq sends a message to the terrorists of the world that "it’s effective to blow things up." The implications of that message are not lost on gold stock investors.


Bill Bonner, back in Paris…

*** The latest inflation numbers show the cost of living rising at 1.7% over the last 12 months. Hourly wage income rose at the same amount. Spending continues to increase two to three times faster. *** Over in Japan, Mr. Mizoguchi and his sidekicks must be starting to sweat. They have invested $320 billion in U.S. government and agency securities over the past 14 months, in an effort to keep the dollar up. Almost every day, in yen terms, the value of those assets goes down. If they stop buying U.S. paper, their companies can’t make money selling products to Americans. But what’s the point of making money…if you have to lend it back to your deadbeat customers?

*** And here’s a first-hand report from MoneyWeek editor and colleague Merryn Somerset-Webb, reporting from the land of raw fish: "Tokyo has changed since I was last here – the extent of the construction is astounding. The new development of Roppongi hills has changed the center of town so much it is totally disorientating to anyone who knew the old Tokyo. A lot of my old haunts are long, long gone and the city which is by nature rather scruffy seems shinier and shinier. It’s also cheap – much much cheaper than London – everything from taxis to wine. Foreigners are all very excited about the leveling out [bottoming] of the property market (quite something when you consider that prices have fallen 1-2% a year for god knows how many years) but the locals are so jaded after years of false alarms they are calling this flattening of prices a mini bubble.

"[There is] still some feel here of a city in recession, though the new Prada building is quite wonderful and everyone keeps telling me about the 2km line outside the new Luis Vuitton shop when it opened. But getting a taxi is easier than it ever was…and the rather nice, new restaurant I had dinner in last night was empty except for our party."

*** London is amazingly expensive. A simple lunch for two – which would have cost about $30 in Paris – set us back $70 in the British capital. We don’t know how the English do it. Salary levels are comparable to those in France and America. But living costs seem much higher. An observation: the English do not seem to live as well.

"I feel like I’m getting a glimpse into the future…I’m downsizing," said colleague Dan Denning, who recently moved to London. "At the margin, I have to cut back here. Everything is so expensive…I have to watch how I spend my money. This is what I expect will happen throughout America when the dollar goes down and interest rates go up. People will have to tighten their belts and sharpen their wits."

[Ed note: By the way, Dan will be joining Agora Travel on a first-hand investigation of the Pao Mo bubble in China, from May 20-30. Dan will be getting up close and personal with at least four companies planning to go public on the U.S. stock exchanges in the next four to eight months…as well as exploring the delights of one of the most dynamic economies on the planet.

*** France, or at least Paris, is in a state of alert. Threats have been received from Islamic terrorists groups. If they are serious threats, it marks a nasty turn in the history of Muslim terrorism. Until now, it appeared that terrorists were motivated by a desire to protect their own holy lands from foreign occupiers. Thus attacks against the U.S. and Spain, arguably, were the result of the presence of their troops in Muslim countries.

To the French, with a large Islamic minority, the solution seemed simple enough: don’t meddle around in the Middle East. But suddenly, a kind of darkness settled over the City of Light…when a group acting in the name of Allah said it will attack the French because of France’s ban on headscarves in the public schools. Oh là là. France imposed the ban to try to avoid religious conflicts in its public schools. If the threats turn into acts…it will mark a large and sinister milestone: terrorists will be attempting to change the internal policies of a non-Islamic country.

*** Byron King: "The other day, I was talking with a couple of people with whom I work. We were discussing bankruptcy law and procedure. I said that recently, since moving to electronic filing, it seems to me that the clerks at the Bankruptcy Court now have increased power. These civil servants sit behind bullet-proof glass, staring at their screens, clicking away at the bankruptcy petitions people file by the armload, with the power of debt discharge in their little mouses. Whatever the clerks enter into the system is what the Trustees and Judges see, and this input controls the entire process.

"One of my colleagues chimed in something along the lines of, ‘Just think, we have all these hard-working people at the Fed, down in Washington, creating credit. And we have all these hard-working clerks in the Bankruptcy Courts, all over the country, discharging debt. It is as if there is a circle of credit creation and destruction, and it is all one big government program.’

"Yep. Exactly. Credit, debt and discharge. Courtesy of the debt magicians, dealing with the ‘money illusion’ of the world of the dollar standard. Ex nihil, nihil."

The Daily Reckoning