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Message: how deflation leads to hyperinflation

how deflation leads to hyperinflation

posted on Dec 16, 2008 07:14AM

this article by eric de carbonnel illustrates how deflation leads to hyperinflation. even the weimar republic experienced deflation in 1920. he explains that velocity of money becomes more important than changes in the money supply. hyperinflation is the result when people lose confidence in the currency, and spend it as quickly as they can. there is a chart which i couldn't paste in here.



I keep reading about the dollar being a "new multi-year bull market" and that the US is headed for "Japan style deflation". Frankly, it is a little tiring. The people making these arguments should know better.

Deflation Vs Hyperinflation

Yes, there is debt deflation, and the overall money supply is shrinking as a result. However, those calling for "multi-year bull market" for the US dollar are insane. These individuals need to review basic monetary theory . The money supply is only one of three factors that determine whether prices rise or fall. The other two are the changes in the velocity of money and the real output of the economy. The danger of hyperinflation lies in a dramatic increase in the velocity of money due to a loss of confidence, not in changes in the money supply.

Confidence and the velocity of money

When confidence in an issuing authority crumbles, money starts flowing through the economy at a feverish pace. For example, in normal, noninflationary times the money supply might be equivalent to three months of output, but in a period of hyperinflation it might drop to two weeks worth of output. Since increases in the velocity of money have the same impact on prices as increases in the money supply, a 1000% increase in the velocity of money (typical in any period of hyperinflation) is equivalent to a 1000% increase in the money supply. Due to its effects on the velocity of money, the ebb and flow of confidence have a much greater impact on the short-term trend of prices then changes in the money supply.

Deflation can create Hyperinflation

It is no accident that many of the worst periods of hyperinflation are preceded by deflation. In fiat currencies with high levels of government debt, severe cases of deflation cause a loss of confidence in the nation's currency by shrinking the economy and making the government's debt appear increasingly unsustainable. The loss of confidence then causes the flow of money to speed up as individuals become desperate to exchange cash for real goods as fast as possible, producing hyperinflation.

As an example of deflation leading to hyperinflation, consider the case of the Weimar Republic . In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honor checks, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the mark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%.

Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and the shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experience one of the worst cases of hyperinflation in modern economic history. Billions of hoarded marks came out of hiding and entered the marketplace.



http://www.marketoracle.co.uk/Articl...

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