The question of the day is:
Can you have hyperinflation without a significant increase in the money supply?

First, to answer this question, we must define hyperinflation.  Austrian economists usually define inflation as an increase in the money supply.  By this definition, the only way you can have inflation (or hyperinflation) is if the money supply is increasing.

But let’s debate the question using the now commonly used definition of inflation.  For the sake of this discussion, let’s say that inflation is the equivalent of price inflation.  For the definition of hyperinflation, let’s say that this means very significant price inflation.  This means that prices are rising very rapidly, probably over 100% per year.  This means that prices may be going up every day, but at the very least, once a month or more.

So can we have massive increases in prices without a significant increase in the money supply?  While the probability is low, it is not impossible.  When we look at the overall price level, there are two sides to the equation.  There is the money supply on one side and there is the demand for money on the other.  They may or may not correlate.

Right now, there is actually a fairly high demand for money.  This means that velocity is low.  It means that money is not changing hands as frequently.  This is actually the equivalent of a decrease in the money supply.  People are frightened of the economy.  There is a lot of uncertainty.  People are paying down debts and saving money (if they can) for a rainy day, at least more than they were doing before.

Velocity occurs based on how people are thinking.  If people are scared and feel the need to hold some cash, velocity will be low.  If times are good, people may be willing to spend more and velocity will be higher.  But there is also a scenario where times are not necessarily good and yet velocity is high.  If people fear that their money will not buy as much tomorrow as it does today, they may go ahead and spend it and get rid of it before it loses more value.  People will buy “stuff”, because at least the “stuff” will hold its value better.

This last scenario is most typical in an environment of big increases in the money supply.  This is what happens in countries that experience hyperinflation.  It is a bad cycle.  This is what happened in 1920’s Germany.  It came to a point where prices were going up much faster than the money supply.  This was due to extremely high velocity.  People did not want to hold cash.  They wanted to spend it immediately.  People would get their paycheck and immediately run to the store to buy food with it before the food prices went up again.

Usually in a high velocity environment, people are expecting the money supply to continue to increase.  But it is technically possible to have high velocity without an increasing money supply.  People may just expect it to increase or they may lose faith in the currency for some other reason.  It is technically possible that the majority of Americans will wake up tomorrow and start reading the Mises Institute website and become Austrian economists.  Based on public opinion, especially if legal tender laws were repealed, people could all of a sudden reject the fiat currency and turn to gold or some other money.  It would even be possible for the market to turn away from gold because it found something better.

So to answer the above question, because of the velocity of money (how quickly money changes hands), it is possible to have runaway price inflation without a dramatic increase in the money supply.

Because we live in a world of fiat money, it is hard to imagine a society that functions with free money and free markets.  Many people, libertarians included, forget that so much of what we are accustomed to only takes place because of fiat money.

Let’s imagine a society with a truly free market.  If this society had any government, the only thing the government would do would be to protect people and their property and enforce contracts.  This means there would be no or minimal taxes and no or minimal government regulations (the market would have regulations).  It also means there would be no legal tender laws and no central bank creating money out of thin air.

Now let’s say that the free market in this society chooses to use gold or silver (or perhaps both) as money.  People would be free to use whatever they want, but most likely one or two things would win out and become money for society.  People would obtain gold or silver so that they could save, invest, and buy other things.

For the sake of discussion, let’s say that banks did not participate in fractional reserve banking.  I would argue that even in a free banking system, banks would keep close to 100% reserves anyway, but either way, let’s say for this discussion that all banks kept 100% reserves.  Now, this is not realistic, but for discussion sake, let’s also say that the amount of money (gold or silver) does not change.  There is no new mining and the money stays within this society.

Now, that is a lot of assumptions, but what would this society look like?  Besides the fact that it would flourish, there would be a lot of differences with what we have in current day America.  For example, we are accustomed to wages going up (at least before a couple of years ago).  This would not really happen any longer as a whole, at least not in nominal terms.

Over time, we usually see stock prices go up.  We usually see housing prices go up.  We usually see the prices of consumer products go up.  But this would all go away.  Housing might actually get cheaper over time.  While stocks would still go up and down, the overall stock market would not likely go up.  This is hard to fathom.  So why would anyone buy stocks?  Well, any one particular stock can go up, but you could still buy index funds because they would pay dividends (especially with no tax on dividends).

This is really tough for people to grasp.  Wages would not go up.  You would have the same money supply, so how could they go up?  Where would the money come from?  But this is all ok.

Many people think that as the number of goods and services in society increases, that the money supply must increase to accommodate this.  But it just isn’t true.  What happens is that your money becomes worth more.  With the same amount of gold or silver, you can buy more today than you could yesterday.  We would live in a world like the electronics industry.  Things would get better and cheaper as time goes on.  You wouldn’t see a rise in nominal wages, but your standard of living would shoot up as your wages could buy so much more.

This is what actually happened in much of 19th century America.  Prices actually fell gradually.  But it wasn’t some scary deflation.  It was an increase in purchasing power due to increased investment, technology, and productivity.  This is the way it should be.  We should expect more for our dollar tomorrow, but instead we get less.  We have been brainwashed by fiat money.

Gary North has written an interesting and insightful piece (as usual).  He basically points out that some things have gotten cheaper and that we should factor in the quality of products when we are looking at the price.

I can give my own example.  More than ten years ago, I bought a 27 inch television for about $400.  I would not be able to buy the same television today, unless I pick it up used on Ebay or somewhere like that.  If I spent $400 on a television today, I would get something bigger (screen size), but it would be lighter and it would only be a few inches thick.  It would have more features with a higher quality.  This is definitely a reduction in price.

I first read Gary North’s article on his website and I was wondering if Lew Rockwell would publish it.  This could actually be a controversial piece amongst some libertarians.  There are a lot of libertarians who, to say it politely, don’t think much of the Bureau of Labor Statistics and the Consumer Price Index (CPI).  There are a lot of free market thinkers who believe that the CPI is manipulated to understate price inflation and thus make us think we are better off than we really are.  I happen to agree with Gary North on this subject (I believe Harry Browne had a similar opinion) and think that the CPI is useful for measuring trends.  Of course it will never be totally accurate.  That is impossible.  But it would be just as impossible to come up with a totally accurate number if it were done by a non-government group.  It is impossible because of hedonics.

Now, I would not be one to take Gary North at task on an article relating to anything monetary, and I don’t think I’ll start here, but I do have an extra point to make.  Yes, some things, particularly those in the technology sector, are getting cheaper.  Yes, this is due to increased investment and productivity over time. Yes, a computer that costs one thousand dollars today that is twice as fast as a one thousand dollar computer a year ago is a price reduction for what you are getting.  With all of that said, this just shows us one thing.  In sectors where prices are dropping, productivity is outpacing monetary inflation, but we have absolutely no idea how much we have of each.

If there is no increase in technology or productivity and prices stay flat, then price inflation really is zero.  If productivity and technology are increasing rapidly and prices stay flat, then price inflation due to monetary policy is actually high.  It is just being offset by the productivity.

I think this is why the CPI is so annoying to so many libertarians.  While the CPI is supposed to measure the price index, libertarians equate it to monetary policy.  And while there is certainly a correlation, the CPI is really measuring two things that are opposing forces.  The CPI is measuring price inflation due to monetary policy and price deflation due to gains in productivity.  It is possible to have them go the other way, but not likely, especially in today’s world of central banking.  Of course, you can also see prices in things like education and healthcare go up faster because of interference by government.

Because of hedonics, it is impossible to know how much of an effect monetary policy has vs. the effect of productivity and technology.  It is obvious with televisions, computers, cell phones, digital information, and most other things technology, that we have seen rapid gains and they show no signs of slowing down.  This has allowed prices to go down and quality to go up, in spite of continued monetary inflation by the Federal Reserve.

The CPI really is a contest in many ways between the free market (productivity) and monetary policy (money debasement).

There was an article the other day published on LRC (via Dow Theory Letters) by Richard Russell.  He says this is the most popular piece he’s published in 40 years.  It is a short read and I think worth it if you haven’t seen it already.

His second rule of not losing money sounds so ridiculous, but it really is true.  This isn’t to say that you shouldn’t take some risk, but you should manage your risk and limit your losses.

The first rule is about compounding interest.  I think this is a very important lesson to teach kids.  I’m not sure what age is best as it probably varies depending on maturity.  But certainly by high school, it is a good lesson to teach.  If you look at the subject beyond an individual investor, it also explains the wealth of nations.  When a nation is grounded in freedom and property rights, the economy will flourish.  While the gains in overall wealth are hard to see over a short period of time, the growth compounds.  You will get to a point where you can save and invest more, while also consuming more.  Again, this goes for individuals or for the general wealth of a nation or area.

There is one thing in this piece that I have to take exception with.  He gives an example of the power of compounding interest and he uses an interest rate of 10%.  Now I understand that he is using a nice clean number and I’m not sure when this was originally written, but it certainly doesn’t apply to our times today.

The biggest problem is that the real rate of return right now (adjusting for inflation) is negative, particularly if you are investing in short-term bonds or money market funds.  If you take your money and stick it in a savings account right now, you are losing money.  While this idea of compounding interest is important, it’s not going to happen in today’s environment with the investments he recommends.

While this is a good educational piece, I would make sure to pair it with some writing on the Permanent Portfolio as described by Harry Browne.  His strategy is to divide up your investments into 4 equal parts.  The 4 parts are stocks, long-term government bonds, gold, and cash (or near cash equivalent).  Anyone who has used this strategy has seen nice and steady returns through the years with very few bumps.  This is a strategy that will protect you against a collapsing dollar, something that isn’t addressed in this article.

Hosni Mubarak, who has been president (dictator) of Egypt for almost 30 years, says he will step down and hold elections.  This could be several months away, but it is not all that likely that he will make it through the weekend.  Protesters are demanding that he step down now.  Mubarak, of course, is claiming that he was going to step down anyway (yeah, right).

This blog is usually about the economy and investments, but it also has a libertarian theme.  The situation in Egypt is too important to ignore right now and it will likely have an impact on our investments too.  We are seeing a revolution take place, much like the demise of the Soviet Empire in the last 80’s and early 90’s.

This situation is not just in Egypt.  It started in Tunisia where the dictator of 23 years there was ousted.  We are seeing protests in Jordan and Yemen.  All of the Arab states, particularly those with U.S. government backed dictators, are in jeopardy.  Courageousness can spread quickly.

The biggest news would be if Saudi Arabia started stirring.  Just like Egypt, Saudi Arabia receives billions of dollars in U.S. welfare and most of it goes to support the totalitarian government.  Considering how much U.S. politicians like to talk about spreading democracy, they sure do support a lot of dictators.

If the House of Saud were to topple, it will have a lot implications on the rest of the world.  Overall, it would be a good thing, especially if it moves the people towards liberty.  It might drive the price of oil to the sky in the short-term because of uncertainty.  In fact, I think a small speculation on an ETF or stock that is correlated to the price of oil would not be a bad bet right now.  I could certainly be wrong, but there seems to be a lot more reward potential than risk right now.

Unless there is an all-out war, I don’t think the oil supplies will be interrupted for long.  For whoever is in control of the oil supplies, it is in their best interest to sell it.  So if you do speculate on an oil play, it would also be wise to take some profits if they come.  Oil and gold both went up big last Friday, but by Monday morning they had settled down.  Once people get more comfortable with the situation (like in Egypt), the market tends to settle down.  The same could happen in Saudi Arabia if there end up being protests there.

This is an historic time we live in.  This all shows that there is hope for liberty in our future.  Technology is getting the truth out like never before.  We should embrace this technology and encourage others to do so.  We should spread the word of liberty.  We should help others see how much better their lives would be with more liberty and less government.  This goes for everywhere.

Gary North has written an excellent article describing the revolution that has taken place in the last month.  The internet has enabled people to communicate as never before and it is what allowed the people of Tunisia to topple their government.  This has encouraged others to attempt the same, most notably right now in Egypt, but also in Yemen, Jordan and others.  All of the Arab states may be on the brink of revolution.

There is a competition going on in the world.  It is government vs. technology.  The real fight is between government and the people at large, but it is technology that is allowing people to fight back.  Technology has meant more information and communication than ever before.  It is information that cannot be controlled by governments.  This is the biggest enemy to government.

Governments can only exist when they have some kind of consent from the populace.  As this consent is withdrawn, governments weaken and will eventually fall.  Revolution does not require violence.  It requires education and changing the hearts and minds of people.  When enough people realize that the government is not only not helping them, but is actually hurting them far more, then the government cannot stand for long.

As Gary North indicates in this and other writings, technology cannot be stopped.  The increases in speed and new technology is like nothing we’ve seen before.  If you buy a computer today, it is faster than almost anything that existed just a few years ago.  The technology gets better and cheaper and it is at an exponential rate.

It is actually very difficult to understand the times that we are in.  I cannot fathom it.  We really don’t know what our world will look like in 20 years.  Government is the only thing that can stop technology from continuing its dramatic increases (except for maybe a giant meteor or some other unknown).  But technology is what is allowing people to communicate and organize and thus de-legitemize government.  It is a race of big government and technology and technology is winning hands down.

I am pessimistic for the short-term prospects of the American economy.  All of the fiat money and government bureaucracy is bad for business.  It will have to correct at some point.  But the long-term outlook is actually quite good.  We cannot begin to understand just how much we will have in a couple of decades.  The internet revolution has been unbelievable in less than 20 years.  I remember I got my first email account in 1993.  There was no YouTube, Google, Wikipedia, Facebook, and millions of others.  In fact, most of these didn’t event exist 10 years ago.

If you are ever feeling down about the prospects for liberty, just think of the electronics that exist today.  We are in a digital revolution, but most people fail to acknowledge the significance or that we are even in one.

For the last couple of months, we haven’t really seen the adjusted monetary base shoot up.  Bernanke announced, in early November, the Fed’s plan to buy an additional $75 billion in U.S. bonds each month for 8 months.  What he said did not seem to be coinciding with the chart of the adjusted monetary base, which is the monetary measure that the Fed directly controls.

Finally, we can see that the Fed has done some major buying.  The monetary base shot up in one week as reported last Thursday.  The updates come out each week, usually on Thursday.

http://research.stlouisfed.org/publications/usfd/page3.pdf

Now look at the one-year chart for excess reserves held by commercial banks:

There is something very significant happening in the world right now.  At this moment, it is appearing in Egypt.  For several days, there have been massive protests in Egypt, and it seems to be directly aimed at the Egyptian government.

Like most conflicts that happen in this world, it is not necessarily a black and white case of good vs. evil.  I’m sure there are different people protesting for different reasons.  Some of it may be a mob mentality.  Some may be demanding more government handouts.  But there is a real sense that a good portion of the mentality is that people are fed up with their brutal government.  This all came about in Egypt right on the heels of similar protests in Tunisia.

Overall, this could be a good thing for our future.  Of course, any violence that occurs from either side is wrong, unless it is purely in self defense.  It is hard to see how anyone on the side of the Egyptian government can claim self defense.  The biggest significance of what is happening in Egypt is that the mentality seems to be spreading.

There is an article on CNN (via Drudge) that says the Saudi king is slamming protesters in Egypt who seek to destabilize their country.  Of course, the Saudi government would say this because they are in the same position as Mubarak.  Hosni Mubarak has been the Egyptian president (really dictator) for nearly three decades and the only way he has been able to maintain power for so long is by backing from the U.S. government.  The same can be said for the Saudi family.

Courage is like a virus that can spread easily.  If the people in Saudi Arabia see a toppling of the government in Egypt, they might think it is more possible to topple their own.  Despite what you might hear from Sean Hannity, this is mostly not about radical Islam.  This is about oppressed people throwing off their brutal rulers.

It is hard to say what it would take in the U.S. for something like this to happen.  We have already seen the Tea Party in action, but things tend to be far less violent here, which is a very good thing.  Perhaps when people stop receiving their Social Security checks you will see millions of demonstrators in the streets.

This whole event is quite significant, not just because of Egypt, but because of the precedent it may be setting.  If we see something similar happen to Saudi Arabia, it will impact our economy and investments in a big way.  The situation in Egypt already, at least seemingly, caused gold and oil to spike on Friday.  If something starts happening in Saudi Arabia, watch for oil to shoot by $100 per barrel and way beyond.  Just the fear of a disruption in the oil supply will send prices soaring.

This whole thing could end up being a major part of history.  Just like the falling of the Berlin Wall was a precursor to the falling of the Soviet Union, this event in Egypt could lead to a toppling of a lot of thug dictators in the Middle East and elsewhere.  The U.S. government is in panic mode right now, even if the politicians are trying not to show it.  The U.S. government props up dictators all around the world (and we wonder why there is blowback in the form of terrorism) so that the dictators can bow to U.S. politicians.  These bribes (at U.S. taxpayer expense) may be coming to an end faster than we could have thought.

Let’s pray for peace in Egypt and elsewhere, but let’s also hope that the people can shrug off their rulers. Let’s also hope that the people there turn towards liberty and not towards another thug dictator.  Just as bad would be for them to think that democracy is the answer to their problems so that they can elect a thug as president.  They should seek decentralization and individual liberty.

There is more open talk about U.S. states filing for bankruptcy.  Although I don’t see the Republicans in the House of Representatives doing any great things, it does seem that a Republican majority in the House makes it less likely that state governments will get a bailout from Washington DC.

The states that are the worst off financially are blue states (perhaps not coincidentally).  Some of the states that are in real trouble are Illinois, California, New York, and New Jersey.  Why would the Republicans help in a bailout for states that usually vote Democratic?

It is hard to say which state is the worst.  New Jersey has a Republican governor now and he is actually somewhat fiscally conservative, at least compared to others that we hear the term used for.  New York, while in trouble, did not get as big of a bust in the housing market.  New York City is still a place where a lot of people want to live and work and there isn’t much land there.

I think the two leading contenders for bankruptcy are California and Illinois.  Both state governments are in massive debt and they have almost kicked the can down the road as far as they can.  They are in severe debt.  They are both in a situation similar to Greece or Ireland.  State governments cannot print money to hold off the problem.

This is why state bankruptcies will be a precursor to any implosion in DC.  The federal government can continue to kick the can down the road until it faces massive inflation or hyperinflation.  It can continue to run massive deficits because of the Fed’s monopoly on the money we use.  The states do not have this privilege.  The states will truly run out of money and will be unable to pay the bills.  The only choice will eventually be bankruptcy and dramatic cuts in spending.  Overall, while it will be painful for many, it will be a good thing for the long-term.

If you own any municipal bonds, get out.  If you are dependent on a state or city pension, start saving more money and be prepared for this money to be cut.  If you are in a college pre-paid fund for your child, you might want to consider pulling the money if you can, especially if your child is years away from going to college.

All of this talk of states filing for bankruptcy would have been unheard of just a few years ago.  It just tells us how dire of a situation things are in.

Last night, Obama delivered his state of the union speech.  You can read a full transcript here:
http://www.nytimes.com/2011/01/26/us/politics/26obama-text.html?pagewanted=1&_r=1

Bottom line, I don’t seen anything new here.  It was a typical speech given by a typical Keynesian president.  The conclusion you can reach from the whole thing is that he will try to maintain the status quo of big government, big spending, and continued war.

Obama said that he is proposing a freeze on annual domestic spending (whatever that means) for the next five years.  I’m not sure if that includes Social Security or Medicare, but I doubt it.  There is little chance that his proposal will come to fruition.  He is speaking meaningless words.  But even if it did happen, he says that it will reduce the deficit by more than $400 billion over the next decade.

Let’s make sure we understand the difference between deficit and debt.  The national debt is about $14 trillion.  The annual deficit right now is about $1.5 trillion.  That means we are adding $1.5 trillion every year to the national debt.  So if we reduce the deficit by $400 billion, then that means we will get an annual deficit of $1.1 trillion in a decade.  In other words, we will continue to add more than a trillion dollars a year to the national debt every year for the next decade.  Do the terms “massive inflation” and “default” mean anything now?

Obama also talked about innovation.  He did cite some past innovations that were done with little or no government.  But then he talks about innovations as if the government has to somehow help.  He talked about electric vehicles and high speed rail.  Of course, his plan is to subsidize these things with taxpayer money (or perhaps printed money).

Obama is a Keynesian.  He is a believer in big government, just as Bush before him.  Obama believes that the government has to help innovate.  He does not understand that if something is worth doing, then it shouldn’t have to be subsidized.  As Austrian economists, we talk about malinvestment as it relates to the Fed printing money.  But there is almost always malinvestment when the government spends any money at all.  If consumers want high speed rail, it should be profitable for a business to provide the service without government subsidies.

Obama also mentioned regulations and said that he ordered a review of government regulations.  He said that when we find rules that put an unnecessary burden on businesses, we will fix them.  Um, can you say “Obamacare”?

In conclusion, this speech was nothing new.  The federal government is heading over a cliff.  Maybe it will speed up or slow down a little before reaching the edge, but there is no stopping it.  Prepare accordingly.