Warning – this is likely to be an extremely unpopular post with a lot of people. I apologize in advance for any inconvenience this causes your political biases. I also apologize for the snarkiness in this warning.
Every time I point out that the US government is a contingent currency issuer that can’t “run out of money” the same inevitable response always pops up where someone says that insolvency is really no different than what inflation is because inflation is just a “different type of default”. This can be very misleading. Let me explain.
We reside in a credit based monetary system. That means almost all of the money in our system exists as a result of a simple accounting relationship. Let’s say you have a great idea for a new technology that you think everyone will love and you think this technology will improve living standards. But you don’t have the funding to produce and market the new technology so you go to your local bank to take on a loan. You have excellent credit and maybe even some collateral so the bank is happy to extend you some credit. In doing so the bank creates a loan which creates a deposit for you to go out and spend.
What’s happened here? The money supply has increased. And so has your purchasing power. And you use that purchasing power to go out and build your new technology and sell it. Let’s assume that after a few years of this your technology is a big success, has made many lives better, improved productivity for others and increased the amount of other goods and services your labor hours can currently purchase. In other words, society is better off because of your technology despite the increase in the money supply and the inevitable inflation that will likely accompany this.
The key is understanding the simple point that enhancements in productivity allow us to consume and produce more goods and service with the same number of labor hours! Said differently, your living standard improves despite an increase in inflation.
The US economy over the last 100+ years is basically one big example of this relationship between credit, inflation and output. Here are some long-term charts displaying what was essentially described above:
In a credit based monetary system credit IS money. And the supply of credit will expand over time as the economy grows to support a larger credit base. Yes, at times this system will inevitably become unstable because its participants will take on more credit than they can afford or make other irrational decisions that cause imbalances, but over the long-term the economy is basically one big credit creating productivity enhancing machine that pretty much ALWAYS has higher inflation, higher credit levels AND, most importantly, increased productivity and output.
So no, it’s not right to say that higher inflation is a “different form of default”. Despite the decline in the purchasing power of the dollar over the last 100+ years we are all actually better off because our productivity allows us to purchase more goods and services with the same number of labor hours. Inflation and insolvency are totally different animals with very different causes. If we want to understand these things and how they impact our lives then we need to better understand the causes here.
While a moderate rate of inflation could be totally normal it is important to note that a hyperinflation is a very different situation. A hyperinflation is usually a full blown rejection of the currency and asset allocators are trading the currency in exchange for almost anything else. In this case the government has effectively run out of willing holders of its liabilities. And although the government will not likely default on itself it does have difficulty finding willing private sector holders of its liabilities. Though this is not a technical bankruptcy in nominal terms it is essentially a bankruptcy in real terms.
When considering this scenario it’s important to understand a crucial point – hyperinflation has many causes that are generally different from an insolvency. Remember, a currency issuer with its own central bank is not going to “run out of money” because it has its own bank which can print money. An insolvency is when a debtor runs out of money. The government doesn’t run out of money during a hyperinflation, but it can run out of private sector holders of its liabilities. While it’s commonly believed that this results from “printing money” the reality is that printing money is usually the result of other exogenous forces including:
- Collapse in production.
- Rampant government corruption.
- Loss of a war.
- Regime change or regime collapse.
- Loss of monetary sovereignty generally via a pegged currency or foreign denominated debt.
- Loss of monetary sovereignty due to collapse in private sector production.
I want to emphasize that a hyperinflation can have different causes than an insolvency so they are similar, but different diseases. As a general rule it is safe to argue that a hyperinflation generally occurs when the government prints money in response to an exogenous event that resulted in a production collapse. In this case the aggregate economy has reduced demand for government credit (money) AND reduced demand for goods and services denominated in that currency. In an insolvency you have high demand for credit and a shortage in output that gives you access to credit. In other words, insolvency is a microeconomic event while hyperinflation is a macroeconomic event. So they are different but similar diseases that inflict governments in different ways than they inflict private households or businesses.
This is not to say that the government cannot cause hyperinflation. It absolutely can, but it’s important to understand what generally causes hyperinflation. While many believe it is “printing money” it is usually other exogenous factors and understanding the importance of this difference is oftentimes the mistake that people make when they confuse a government default for a household or business default. So while hyperinflation and insolvency are devastating financial events they often have different causes and in the context of government finances that is an important distinction to understand.
Please read the following pieces for some important related topics:
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.