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Bernanke's Dilemma: Hyperinflation and the US Dollar

Bernanke's Dilemma: Hyperinflation and the US Dollar

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Published by Ron Hera
With interest rates near 0% and with unprecedented government debt and deficit spending beyond sustainable levels there is a clear risk of high inflation or hyperinflation if inflationary forces are not counterbalanced with a heavy hand. In theory, high inflation or hyperinflation could be prevented by restricting the flow of money and credit to consumers and businesses. Such a policy would exert deflationary pressure on the US dollar within the domestic US economy since principal and interest payments on existing debt would drain money from circulation. While preventing inflation temporarily, such a policy would not succeed in the long run because, in addition to offsetting inflation, deflation depresses economic activity and results in debt defaults.
With interest rates near 0% and with unprecedented government debt and deficit spending beyond sustainable levels there is a clear risk of high inflation or hyperinflation if inflationary forces are not counterbalanced with a heavy hand. In theory, high inflation or hyperinflation could be prevented by restricting the flow of money and credit to consumers and businesses. Such a policy would exert deflationary pressure on the US dollar within the domestic US economy since principal and interest payments on existing debt would drain money from circulation. While preventing inflation temporarily, such a policy would not succeed in the long run because, in addition to offsetting inflation, deflation depresses economic activity and results in debt defaults.

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Published by: Ron Hera on Mar 18, 2010
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Hera Research, LLC
7205 Martin Way East, Suite 72Olympia, WA 98516U.S.A.+1 (360) 339-8541 phone+1 (360) 339-8542 faxhttp://www.heraresearch.com/
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Bernanke’s Dilemma:HyperinflationandtheUSDollar
By Ron HeraMarch9, 2010©2010 Hera Research, LLCBen Bernanke, Chairman of the US Federal Reserve, faces aSisyphean task becauseUS banksareexperiencingdebt deflation and, because lending isnowatmuch lowerlevels, monetarydeflation is encumbering the domestic US economy as existing debts continue to be serviced.Government deficit spending can only offsetlowerconsumer spending to a degree, and themushrooming debt of the US governmentraises the question of whether the US can repay or rollover its debt obligations, given that tax receipts arelikely tofall.Despite deflationary pressure,the value of the US dollar is in a downtrendpointing tohigher prices for imported goods andenergy. Devaluing the US dollar will reduce the value of debts in real terms,thus it can makedebt levels sustainable,but higher prices will exacerbate debt defaults, worsening the condition of US banks.Mr.Bernanke’s dilemma is how tosalvagethe balance sheets of US bankswithoutsparking high inflationor unleashing hyperinflation.Where the US dollar is concerned, opinions on hyperinflation range from the view thathyperinflation of the world reserve currency is impossible in principle (because, for example, thevalues of other currencies are linked to that of the US dollar), to the view that hyperinflation of the US dollar has already happened and that all that remains are the consequences.The two mostwidely accepted theories of hyperinflationarethe monetary model, where a positive feedback cycle is caused by a disproportionate increase in the velocity of money as a consequence of increasing the money supply too quickly, and the confidence model, where the monetaryauthority issuing a given currency is perceivedto beinsolvent or no longer legitimate.Theviewthat hyperinflationis the inevitable result ofa central bank issuing too much money or ofa government taking on too much debt, while correct, both states the obvious andpresupposesthat some previouslyknownor predictable limit is reached.The ability to service debtis onesuch measure, but the value of a debt in real terms depends on the value of the currency.In practice, hyperinflation is recognized only after the inexorable death spiralof a currencyhas begun. Detecting it in advance is another matter entirely.Mathematical models of hyperinflation,such aspredicting years between redenomination basedon inflation rates or applying the quantity theory of money, describe what ishappeningbutnotwhy.Usingthe monetary modelalone makesit difficult toexplainapparentcounterexampleswherehigh levels of sovereign debtcompared to a nation’s gross domestic product (GDP) or monetizationdid not result in hyperinflation.The confidence model seems to suggest that hyperinflation can be explained by crowd psychology where hyperinflation is analogous to a market mania or is an example of masshysteria. The idea that hyperinflation is only a crisis of confidence, i.e., that it is apsychological phenomenon, not only lacks predictive value butimplies thathyperinflation can be prevented bymanipulating public opinion regardless of mathematical realities.
 
©2010 Hera Research, LLC
2When a nation’s bond market collapses, so does its currency.The view that hyperinflationisfundamentallycaused byfailed bond issues suggests that what is of interest are the reasons whyanation’s bond market breaks down, along withindications ofdevelopingbond market distress.One fact that is clear in every historical exampleof hyperinflationis the rejection of the currencyof a given country either by other countries or by its own citizens.The simplest explanation ohyperinflation is that when the credibility of a government, or of its central bank, breaks down,the recognition of this fact is expressed as a race to shedthecurrencyandto divest ofthegovernment’sbonds.Oneway toevaluate the possibility ofhyperinflation isthereforetogaugethetransparency, completenessandveracityof government and central bank statementsregardingtheirbalancesheets, budgetsandbond issues. Incomplete or inaccurate informationand propaganda contrary to empirical evidence areproverbial red flagssignalingthat credibility may belacking andthatconfidence is thereforemisplaced.
Between Scylla and Charybdis
Growth in the US monetary basehas beencited as evidence ofincipienthyperinflation but, whilea distortion in theUSfinancial system is apparent, the currency in question is not in circulationand the effect isthat of re-inflation since US banks have suffered massive losses linked to the USmortgage market.
Thegrowth in the US monetary base byover$1 trillion since 2008represents currency heldwithin the banking systemonreserve, whichincreasesthe abilityof US banksto absorbfurther losses.
 
©2010 Hera Research, LLC
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Whilemore thandoubling theUS dollarmonetary base in less than 2 yearsis viewed by some as printing too much money,high inflation orhyperinflationhaveyet to strike.Althoughmoney hasshifted out of the broad US economyandinto thebankingsystem, the excess liquidity exists inthe form of bank reserves and, despite the fact thatinflation is always and everywhere a monetary phenomenon,ifbank reserves areconsidered separately frominterest rates andlending activitytheyhave littledirect impact onprices in the broad US economy. In fact, thewidestmeasure of the US money supply is contracting andthe broad US economy is in the grip of debt andmonetary deflation.

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