What Does Austrian Theory Say About Hyperinflation?

Hi,

I'm slowly making my way through Human Action, and have read many of the articles and discussions on this site to try to come up to speed.  I think I understand at a base level the Austrian theory of inflation, the business cycle, etc., but I clearly have a lot more to learn.

Peter Schiff, who seems to be a pretty solid believer in the Austrian School, believes a collapse of the US Dollar is imminent, and is therefore advising his clients to get out of the dollar.  What I don't quite understand is this.  Ok, say the US Dollar does experience hyperinflation for the reason he states in his book.  What then?  In the Austrian sense, a rise in prices will result from this hyperinflation, presumably causing the price of US Stocks to rise as well in these "hyperinflated dollar" terms.  But will they rise in real terms?  And will they rise faster or slower in real terms than, say, Australian Stocks, which, for the sake of argument, we assume are denominated in a currency being inflated at a far more modest pace than that of the rapidly collapsing US Dollar?

Equivalently stated, at the end of the carniage, does N shares of the S&P 500 buy more or less "real stuff" than the same number of shares of an analogous Australian Index?  Is the ravenous damage caused by hyperinflation in the US so profound that it would be hard to envision those US Equities having the same "real" purchasing power as the Australian counterpart?  Or is there absolutely no possible way of making this determination due to the complexity and the myraid variables involved?  (Remember, I stated as a given for this thought experiment that the Australian Money Supply would grow at a vastly slower rate than the hyperinflating US Dollar.)

Maybe I could try to state this another way to illustrate the question.  Let's say I buy a backet of US stocks for 100oz of gold, and a very similar basket of Australian stocks for 100oz of gold.  After 5-10 years of hyperinflation in the US, and 5-10 years of very slow money supply growth in Australia, for the sake of argument, which backet of stocks could be sold for more ounces of gold at the end of those 5-10 years?  Does Austrian Theory have anything to say about this scenario?  Perhaps, that, all things being equal, the standard of living in a country with a more stable money supply is likely to grow faster than that of a country experiencing hyperinflation?  Or is the question simply impossible to answer?

More importantly, does Mr. Schiff's investment strategy -- buying foreign companies in countries with hard currencies -- necessarily follow from his prediction of a collapse in the US Dollar?

I'd appreciate any thoughts on this.

Thanks,
WB

It sounds like you are looking for investment advice.  The best place for that would be to contact Peter himself.  To my knowledge, Rothbard, Hayek and Mises weren't the belles of Wall Street with their own personal finances.

The way I see it is this.  When a currency goes hyper, real wealth will flee to other forms of money.  The need to store wealth in a form suitable for exchange will not go away, and so you can expect to see a strengthening of other currencies in relation to the US Dollar based solely on increased demand, not an increase in the soundness of the economy or market that currency represents.

Take the Canadian dollar.  It is at or near par now for some time with the USD.  In 2002, it was around 1.50 : 1.  Has the Canadian economy become more prosperous in that time?  Certainly the energy sector is doing well, but manufacturing has taken a large hit.  Inflation is rapidly growing, just as every where else.

If I was an American investor, in Canadian dollar denominated investments, I might not only profit from being in profitable sectors, but also being paid in Canadian dollars, which have seen gains in currency markets against the US.  This is why Peter's investment strategies are not only about being invested outside the US, and being denominated in foreign currencies BUT ALSO receiving dividends, or as he puts it "cash on the barrel head".

If your question is whether or not one could win REAL gains in a hyperinflationary currency vs. a non-hyper inflationary currency, I'd say that my instincts say that hyper inflation is a deterrent and an opposing force to the store or creation of true wealth.  It's simply too difficult to make sound decisions when the ability to ascertain prices is not stable.

Hmm, I'd guess it depends on the exchange value of the currency. As the dollar becomes increasingly less able to buy goods relative to other currencies, the other currencies will see a rise in their relative exchange value, and so it would be sensible to switch to the currency that is better able to preserve its value. I might be wrong, of course. One thing is for sure: in any hyperinflation, the currency may lose all its worth, becoming effectively worthless, giving way to another currency.

-Jon

 First, I think we need to clarify some things. Inflation will not cause the real value of stocks to remain the same. The value of the stocks will remain the same in nominal terms plus dividends plus any increases in value. Secondly, the US will not face hyperinflation. Hyperinflation is the state where a currency is completely destroyed, when your currency is being devalued by the minute, literally. We are not in this position nor does Peter Schiff claims we are. What will happen is that the Bernanke Fed will lower interest rates as the economy gets worse because they want to do everything to prevent the collapse of the financial system (which needs to collapse before we can experience genuine economic growth).

In any case, what I'm saying can be seen in the performance of the S&P 500 vs. gold. Gold has done better than the S&P 500 because the nominal value increase (that is original value + increase in value + dividends) of the S&P has not increased faster than monetary expansion, so you end up with less purchasing power. However, since gold has a relatively stable value, gold has appreciated in terms of the USD.

So now about foreign stocks. Schiff's ideas use a "double inflation hedge" strategy if you will. First, he invests in foreign stocks with foreign currency that experiences lower rates of inflation, second, he invests in energy stocks, mining stocks, and other inflation hedges. So as the price of energy and metals go up, the stocks will also rise. At the same time, the foreign currency will appreciate in terms of the USD because foreign central banks have a tighter monetary policy.

In contrast, if you invested in American energy and mining stocks, you would probably beat inflation, but not as well if you invested in foreign energy and mining stocks with foreign currency.

Buying gold, silver, platinum, etc. is simply like buying a very, very inflation proof hard currency. All of these will appreciate against all currencies unless a massive monetary deflation occurs or unless amazing new mines are found with these precious metals (both situations are unlikely to happen).

Thanks for the reply gents.  And thanks for the correction re: the use of the term hyperinflation.

I certainly see how being in cash or fixed-income instruments in a currency that is being rapidly inflated, wherein the CD/bond yields are less than the real rate of inflation, would be an Rx for rapidly losing real wealth.  And, so, it would make sense to move such things into relatively hard currencies.

But I'm a little more confused when it comes to more tangible things, be they commodities or equities of companies that are "close" to commodities.  Certainly the dividends, once paid, fall into the above category until they're (re-)invested, and having them in a relatively hard currency in the interim is a prudent thing.

But how about the "real" value of the commodity/equity one holds?  Does it necessarily follow that the one denominated in the harder currency will be worth more in real terms than the one denominated in a rapdily inflating currency?  One could envision a scenario where the price of the commodity/equity in the inflating currency would skyrocket as the inverse of the purchasing power of that inflating currency, resulting in no net loss of purchasing power of that asset.  And likewise for the one in the harder currency, of course.

If one remains in the USA, physically, then eventually those other currency units would need to be converted to US Dollars to be spendable.  Wouldn't the then prevailing exchange rate between that other currency and US Dollars, be equivalent, perhaps, to the price-in-US-dollars of that dollar-denominated US equity/commodity?  Of course, in both cases, one would end up paying taxes on the gain in fiat-currency-denominated-units when one went to sell those equities, even through the value in real terms may not have moved much at all.  Stupid Government Tricks.

Walter B

wbelhaven:

But how about the "real" value of the commodity/equity one holds?  Does it necessarily follow that the one denominated in the harder currency will be worth more in real terms than the one denominated in a rapdily inflating currency?  One could envision a scenario where the price of the commodity/equity in the inflating currency would skyrocket as the inverse of the purchasing power of that inflating currency, resulting in no net loss of purchasing power of that asset.  And likewise for the one in the harder currency, of course.

I was reading an interesting article about this by a guy called Louis-Vincent Gave. He says:

"As highlighted in The Myth of Reverting Margins, inflation typically takes a much meaner bite out of margins than a recession does. As we wrote back then concerning the US growth/margin relationship: "Margins bear little relationship to the level of GDP or consumption growth. In fact, as the economy accelerated from the mid-1960s to the early 1980s, margins plunged. Similarly, as the economy slowed from the early 1980s to the present, margins accelerated... It is inflation, not growth, which wreaks havoc on profit margins (ironically, if everyone has pricing power, no one makes money)."

He then went on to show some charts showing just that.

From an Austrian point of view, this makes sense. The job of the entrepreneur is to plan what resources (means) he will have available to him in the future with regards to his requirements (ends). Inflation makes this much more difficult to do. Inflation is like a fog, that makes it difficult for supply to meet demand and it's difficult to imagine how all the largest companies in the economy (represented by the main stock indices) could be expected to perform better when their price signals and the very mechansim that is used for exchange is being seriously undermined... so their ability to meet demand (in real terms - which will also be reflected in their inflation adjusted sales) can only be expected to slide in an inflationary environment.

Commodities, on the other hand, are those basic resources which are useful enough to all sectors of the economy to factor into the plans of pretty much all/any entrepreneur - so they should hold their value pretty well in an inflationary environment... Indeed, in inflationary environments you then to end up with distinct shortages of these commodities and so their value tends even to rise (not just hold it's value). This could perhaps be because the way resources are being allocated in an inflationary environment is less efficient (with many of them being wasted in sectors of the economy that are subsidized by the new money brought about by inflation, sectors which are effectively bidding these goods away from where they are really needed and driving the price of obtaining these up - in real terms - for the other genuinely productive sectors of the economy).

I haven't yet read Human Action (I just bought it last week and I'm still in the middle of Menger's Principles) so you may be a little clearer on the details of the above than me... or maybe I'm completely misguided (in which case please don't leave me ranting like a crazy man - I'm open to new ideas)!

I'm not 100% sure what exactly you're asking but I'll take a shot in the dark.

The real value of gold, silver, and many other commodities (but especially precious metals) will appreciate in nominal and real terms around the world as monetary expansion continues. A particular good investment could be silver, since demand is higher than ever and it seems that we might have reached a "peak" in the supply (similar to peak oil). In nominal terms, a commodity might increase more in USD vs. the euro, but in real terms it would appreciate the same amount, the difference would be that the USD would've depreciated faster than the euro.

Also, there really isn't any one set exchange rate. Banks exchange your money and different banks will value the money differently. Overall, using the euro as a benchmark, if the USD depreciates relative to the euro, than more banks will exchange more USDs in exchange for less euros (which means the euro appreciated which is a good thing if you invested using that currency). The key is really the monetary policy of the central bank controlling a given currency. The ECB follows a stricter monetary policy than the Fed, which is one reason you might to choose to invest in euros. Other central banks around the world also follow stricter monetary policies than the Bernanke Fed.

But when investing in stocks in the US, you have to be aware that you'll probably lose out in terms of inflation. You'd need upwards of 15% return anually to beat inflation if you're investing using USDs. However, if you invest using a foreign currency, that for the sake of argument has 5% inflation per year, you only need a return upwards of 5% to increase your wealth in real terms. Of course you'd lose a little bit of purchasing power transacting from the foreign currency to the USD, but not a significant amount which is why Peter Schiff argues that it is better to invest in foreign stocks. Even if you're too scared of the stock market, you could make nice profits just by investing in foreign CDs.

For example, I'm Polish and a lot of my family still lives in Poland. The zloty (Polish currency, symbol is PLN) has appreciated considerably compared to the USD recently. Whereas before one USD was about four PLNs, now one USD only buys two PLNs. So if you would've bought PLNs around 2000 and sold them now, you would've doubled your wealth in USD nominal terms. But if you would've put those PLNs into a CD (the rate at one bank I was looking at was about 6%) you would've earned interest on top of that. Of course, you can no longer make as much investing in foreign CDs since part of the reason we saw such high inflation in terms of dollars was because of 9/11 and then way more spending in Iraq than the government expected. Now the Fed isn't expanding the monetary supply as much any more, but it still is doing it at a quicker rate than other central banks. But in the long run you can make huge increases in wealth investing with foreign currency in traditional inflation hedges (mining companies, energy companies, utilities, etc.).

Does that answer your question?

Jimmy, the reason why it become profitable to invest using USDs in recessions is that so far we've only had one inflationary recession: all others have been deflationary. In other words, in almost recession the dollar has actually appreciated relative to true hard currencies like gold and silver. The Great Depression and the Fed under Paul Volcker are two examples.

However, currently it seems that we'll be back in another inflationary recession a la the 70s, which is why people like Peter Schiff have been advocating investing in gold and silver, mining companies, energy companies, and utilities, all of which are sound inflation hedges.

The real market distortion that occurs with inflation isn't just more subsidies. Subsidies aren't that big of a deal, really. The big problem is the market distortion that artificially low interest rates create. As the interest rate is lowered without an increase of spending, the Fed is forced to print more money. The lower interest rate gives off signals that people are saving and investing more, which triggers more investment in capital goods on the side of entrepreneurs.  At the same time, people are consuming the same as they did before, which creates the "disequilibrium" seen in Hayekian triangles between "overconsumption" and "malinvestment." This temporarily creates a boom as businesses become more profitable and as wages rise due to an increase of demand for labor. However, even if the central bank keeps interest rates low, the real interest rate will rise, which will signal people are saving less (when in reality they've been saving the same amount the entire time) because monetary expansion has slowed. This in turn means that a lot of these investments in capital goods weren't as profitable as previously thought, wages fall, businesses that invested a lot in capital goods go under at the same time that businesses that produce capital goods go under. All this new unemployment means that the supply of labor expands, wages fall even more, and saving and consumption also declines. This is what we call a "bust," or a "recession," or a "depression."

Monetary expansion also exists in a free market, as mining of precious metals (which are normally used as the monetary standard) usually outpaces the destruction of old currency. This kind of monetary expansion isn't harmful, however, because the money enters via a different avenue than the banks. By the same token, when the Fed expands the money supply but only gives it to the federal government to spend, we might have inflation, but we won't have a business cycle. The extra government spending is also bad since it increases consumption relative to saving and investment, even though saving and investment are the basis for genuine economic growth. But the key to understanding ABCT is that monetary expansion via the banks when interest rates are artifically lowered is what creates the business cycle.

krazy kaju:

Jimmy, the reason why it become profitable to invest using USDs in recessions is that so far we've only had one inflationary recession: all others have been deflationary.

Erm, not sure I agree with you there. See the following:
  http://mises.org/Community/forums/p/1553/20666.aspx#20666

I think this is a common myth that many people learn in economics classes at school... that never seem to cease repeating the mantra that "recessions are deflationary" just because the Great Depression was. But the Great Depression was also accompanied by monetary contraction.

As Friedman says, inflation is always and everywhere a monetary phenomenon. Whether money is being created or destroyed in a recession will depend on a number of factors. Certainly production will be hit, but will the quantity of reserves in the banking system decrease more than production does? If the answer is yes, then you'll get deflation - if the reserves hold out better than production or even increase, for example because the central bank keeps on a printing, then you'll see inflation. Another thing that might cause inflation is if USD reserves that are presently held in foreign banks come back to the US.

Recessions usually occur because central banks want to put a break on inflation. As such, they raise interest rates which cause deflation. We didn't only see this in the Great Depression but also when Paul Volcker took control of the Fed. The Great Depression deflation was aggravated by bank failures and the like, so it's not the best example, but it does show the basics: the Fed raised rates because they were worried about their gold reserves, so less money was circulating and you saw deflation. Same with Volcker's Fed: higher interest rates to combat inflation threw us into a deeper recession and caused deflation. If you were owning gold in the 70s and didn't sell it before Volcker came to power, you would've lost a huge amount of your purchasing power.

As proof of what I'm saying, I suggest you look at this link:

http://goldprice.org/30-year-gold-price-history.html

That chart shows the historical price of gold in USD since 1971. You can see the price increasing as we have stagflation and then decreasing rapidly when Volcker takes control and raises interest rates and drives us deeper into recession (temporarily). You see this trend repeating itself during other times of recession, like the early 90s and early 2000s.

krazy kaju:

If you were owning gold in the 70s and didn't sell it before Volcker came to power, you would've lost a huge amount of your purchasing power.

Ah, but that's a bad example because gold went from being money to not being money (the US abandonned the gold standard)... so clearly lost a lot of it's value as a result of this.

You saw the chart I linked to in the post I referred to above though right? The one at the St Louis Fed? Looking at that chart, it's pretty clear that recessions are non deflationary - not always, not even most of the time... only about half of the recessions I counted (if you trust official inflation statistics) were deflationary. It's pretty hard to argue with the Fed's numbers on this, since they're liklely to be about the most conservative numbers you'll find on the subject.

Removing the gold exchange standard wouldn't really have changed the price of gold, unless you can somehow prove that the Fed sold massive amounts of gold after the exchange standard was removed. An ounce of gold was valued at $35 while in the market it was worth significantly more.

But when I reviewed M2 and M3 data along with your CPI chart, I think I must admit defeat. It seems that almost every recession has been at least a little bit inflationary.

krazy kaju:

Removing the gold exchange standard wouldn't really have changed the price of gold, unless you can somehow prove that the Fed sold massive amounts of gold after the exchange standard was removed. An ounce of gold was valued at $35 while in the market it was worth significantly more.

I guess. Why do you think the price of gold has been so low for so long then?

krazy kaju:

But when I reviewed M2 and M3 data along with your CPI chart, I think I must admit defeat. It seems that almost every recession has been at least a little bit inflationary.

Things certainly aren't like they said they were in school! And yet presently central governments all over the world are considering lowering interest rates or leaving them on hold (despite high inflation) in expectation of deflation, as a result of the expected recession. The only prices that appear to be going down anywhere though, as far as I can tell, are real estate prices...

The assumption that recessions are deflationary is one that is commonly held by huge number of people though. I think the majority of folks are gearing up for deflation, which is reflected by current bond yeilds... The split between those expecting inflation and those expecting deflation is not 50/50 (as you'd expect if everyone was simply looking at historical data about inflation. This says to me that probably inflation hedges (such as gold) are still underpriced relative to other investments (and certainly relative to bonds). It might be that this recession does in fact turn out to be deflationary, in which case all those bond owners will get away with what appears to be quite a risky bet, on the face of it. If history is any indication then owning bonds is around about as risky as tossing a coin and betting heads or tails, at present.

wbelhaven:

Ok, say the US Dollar does experience hyperinflation for the reason he states in his book.  What then?

"This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money. Such is the phenomenon that occurred in Germany and in other countries that followed a policy of prolonged inflation and that was known as the "flight into real values." Commodity prices rise enormously as do foreign exchange rates, while the price of the domestic money falls almost to zero. The value of the currency collapses, as was the case in Germany in 1923."

Austrian Theory of the Trade Cycle, Ludwig von Mises