Mises Daily Articles
Weimar and Wall StreetTags Financial MarketsU.S. Economy
What is the relationship between Weimar Germany and Wall St. of the late 90s? On the surface, what could be more different? Stock market booms are the best of times while hyperinflation is a nightmare.
In a previous essay, I presented an analysis showing that the long-term bull market in stocks and bonds starting in the early 80s was a form of inflation. Unlike the inflationary period of the 70s, the price adjustments to monetary expansion occurred primarily in financial assets, rather than in consumption goods. Here, parallels will be drawn between our recent stock market mania and the raging inflations that can result in the total destruction of a nation's monetary system.
The upward movement of prices that we call "inflation" results from a greater quantity of money in circulation. The source of this expansion process is the banking system: under the fraudulent system of fiat money and central banking, the central bank can create reserves by buying assets and paying for them with money created out of nothing. Commercial banks have the ability to issue new money, by pyramiding on the base of central bank reserves in a ratio up to some limit imposed by banking regulations.
Hyperinflation is inflation that has burst the bounds of politeness. If not halted, hyperinflation will result in a total rejection of the offending currency as money. Under chronic but contained inflation, money depreciates at a slower and more stable rate, while under hyperinflation the decline is highly variable and unpredictable. Exact measurement of the rate of inflation rates is difficult because the computation of price indexes assumes that something fairly stable is being measured. But annual rates of thousands to millions of percent have been recorded in historic episodes.
the citizens of Yugoslavia were in a constant race against time—buying whatever they could, wherever there was anything to be bought. Prices increased at a rate of 2 per cent per hour or 64 per cent per day. In 1993, hyperinflation reached a record 400,000 billion per cent. In October of that year, 600 grams of pork cost 26 dinars, with the same amount costing 21 billion dinars three months later.
Why do some periods of inflation metastasize into hyperinflation, and others not? A central bank may set out to generate a permanent state of inflation as a matter of policy. But they can only go so far down this road before reaching a fork: one path is to save their monetary system, the other is to destroy it. To save the system, they must stop the printing presses and allow the economy to suffer the pain of unwinding the distortions created by the prior inflation. If the central bank chooses to persevere in their inflation, hyperinflation will be unleashed.
Why must this choice occur? Why cannot a central bank inflate forever? What is to stop us before we reach the point of $1 million Starbucks coffee?
We can imagine the purchasing power of money getting continually lower without ever disappearing altogether, and prices getting continually higher without it ever becoming impossible to obtain commodities in exchange for notes. Eventually this would lead to a situation in which even retail transactions were in terms of millions and billions and even higher figures; but the monetary system itself would remain. (The Theory of Money and Credit II.13.25).
Along with this is the necessity of issuing new denominations of bills with an extra zero (until they run out of dead presidents to feature on the bills). A more drastic measure is to recalibrate the monetary system entirely by trading in the old notes of say, 10,000 for new notes of one "new dollar" or whatever the name of the currency.
The necessity of inflation's ultimate instability can be explained by looking at how demand for money changes a period of inflation. By demand for money, we are referring to the decision by consumers of how much cash they choose to hold for spending needs. Mises: "The service which money renders consists in its being the commodity which is saleable at the best terms. By keeping money in his purse everybody is enabled to buy in the most convenient way any commodity he may want one day."
Each person decides how much cash to hold, not on the basis of the number of dollars or other units, but on the basis of the amount of purchasing power that they think they will need. The amount that a person holds depends on their estimate of what the purchasing power of each unit of money will be at the time when they spend it. This time could be soon, or much later, even years in the future.
Anyone who expects inflation could revise their cash-holding plans to compensate in one of two ways. They could set out to accumulate more units of money to maintain their total purchasing power in spite of loss in the purchasing power of each single unit; or they could change their spending plans by spending what money they do have sooner, while its value is greater, rather than later, when it will be worth less.
Inflation can continue for some time, even at a fairly high rate, if the public chooses to increase their demand for money as each unit becomes worth less and less. People will be more likely to do this if they think that the inflation is temporary, that prices will sooner or later return to "normal" or at least stop going up. Increasing amounts of money are required each year for producers and consumers to carry out (approximately) the same volume of transactions at higher prices. The economy may be growing at some rate but we are assuming that the prices are increasing even faster. If this process could continue forever, then inflation would remain a chronic problem but not reach a crisis.
Once again we turn to von Mises for the insight that before the point of ten billion dollar double mocha lattes, a crucial mass of people will grasp that there is no end to the process of debasement. They see that the inflation is not a temporary affliction that will be cured; that prices will never come back down; that the rate of inflation will not slow; that money not spent now will only buy less in the future. Then, a monetary apostasy is under way.
At first a few, then many individuals reject the medium of exchange by trading all of their cash for goods. As panic builds, everyone frantically seeks any kind of good at all to exchange for the large quantity of money that they had thought necessary to hold during the earlier stage of the inflation. Hyperinflation's cataclysmic ending is the attempt by nearly everyone at the same time to exchange money for goods before its purchasing power has entirely disappeared.
… a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time.;
Weimar Germany's monetary collapse is perhaps the most infamous episode of inflation gone mad. In 1923 Germany, prices rose on an hourly basis. Wage earners were losing purchasing power because the prices of goods were rising faster than their incomes could be adjusted. Melchior Palyi, a college instructor who saw his pay go from 10,000 marks per month to 10 million marks paid twice per day in less than two years' time tells the story of how another professor asked him on the way out of their offices, "'Are you taking the streetcar?' he asked. 'Yes,' I said. 'Let's hurry. The fare will be raised by 6 pm. We may not be able to pay it.'"1
Fiat money derives its purchasing power entirely from its acceptability as a medium of exchange. As the illusion is shattered, it stops being money. But not all individuals reach the point of skepticism at the same moment in time. Initially more farsighted individuals seek to escape from paper, they purchase more sound assets such as gold bullion, land, property, or other durable assets. Further on, sound and durable goods are no longer offered for sale in (the former) money terms at any price. Successively lesser and lesser quality goods are sought out for monetary exchange.
Near the end, as the majority of the population abandon their faith in fiat, any good will do so long as it can be purchased with what is then nearly worthless money. Once nearly everyone believes that the purchasing power of money is or will soon be extinguished entirely, money no longer serves as a medium of exchange.
… when money loses purchasing power from day to day its retention involves a loss. Whoever gets money, therefore, spends it immediately—even by buying something for which he has no present use and maybe even no future use. In the last days of the inflation the employees got their payment daily. At once they handed it over to their wives and these hurried to spend it as quickly as possible by buying at any rate something or other. Nobody wished to retain money, everybody dropped it like a live coal. (Mises, The Great German Inflation)
Gary North tells a story of a German citizen who realized too late that her money was on the way to becoming worthless: " … the truly marketable goods were gone. They were being hoarded. All she found was a large inventory of bedpans. She bought them in late 1923."
At the end of this process, with the monetary system completely destroyed, exchange reverts to a barter system. If some alternative money is available, such as gold coins or some stable foreign currency, the alternative may come into circulation to replace the rejected currency.
Asset Manias as Hyperinflation
Stories abound of the insanity that we remember as the 1990s stock mania. Financial writer William Fleckenstein ran an occasional series of pieces titled The Mania Chronicles, featuring a small sampling of the most egregious stories that passed his way. While tales of ever-increasing absurdities have been attributed by many commentators to "irrational exuberance" or other forms of mass psychosis. When the stock market bubble is viewed a form of hyper-inflation, these otherwise erratic behaviors can also be seen as a response of economic actors to rapidly depreciating money.
Although an increasing quantity of money will eventually show up as increasing prices of something, prices do not all rise by a uniform ratio. If money is created and spent mostly on stocks and bonds, a bull market will result. This bull market could be described as "financial asset inflation". However, during the 90s, a period of raging inflation in financial assets, most analysts believed that "there is no inflation" because it did not show up in the CPI.2
To say that prices are rising and the purchasing power of money is falling are equivalent ways of looking at the same process. The more that prices rise, the fewer goods a single unit of money (e.g. a dollar) can buy. During a bull market in financial assets, the purchasing power of money is falling with respect to stocks and bonds: from one year (or even one month) to the next, an investor can purchase fewer shares with the same amount of money.
Analysts attributing the stock market bubble to mass hysteria are looking solely at asset prices in relation to corporate profits, while assuming that the purchasing power of money itself is reasonably stable. Investors make this mistake by focusing on the nominal prices of their stocks. If they looked at the market as a measure of how fast their money was losing value, they would not be so quick to assume that the price ratios between assets and goods would remain stable, or improve in their favor. Perhaps instead the prices of other goods would adjust upwards to catch up with stocks.
When we look at the stock market bubble as a monetary breakdown, many similarities with hyper-inflationary periods emerge. When stock prices are rising by 50% or more per year, one could equally say that the purchasing power of money with respect to stocks is falling by that amount. The rate at which money was depreciating during this time was quite high. The NASDAQ index appreciated by about 500% in a two-year period prior to its peak in 2000. This rate would be called hyperinflation when experienced in goods prices.
Panic buying takes place in hyper-inflation when the belief is widespread that money will lose its value rapidly. The panic buying of stocks that was in evidence during the late 90s was based on the view that there would be a continued depreciation of the dollar in relation to stocks, so it was preferable to exchange dollars for stocks in the present, rather than waiting for the future when a dollar would purchase even fewer shares.
The rise of increasingly poor quality stock offerings can be seen as a flight into increasingly poor quality of assets, much like the flight from cash into ever poorer quality goods that occurs in a hyper-inflation. At the bubble's peak, everyone believed that the purchasing power of money would continue to depreciate (relative to stock shares), until it was nearly worthless (as a means of purchasing these assets). Dot com IPOs and bed pans have more than a little in common.
The end result of relentless inflation is the rejection of money as the medium of exchange and the reversion to barter. During the final stage of the stock bubble a partial rejection of money as a medium of exchange and a reversion to a barter system (based on stock shares) occurred. In the San Francisco area, between 1998 and 2000, it was impossible to purchase certain types of goods and services for money. A business could not rent commercial real estate, hire corporate lawyers, engage personnel recruiters, or hire employees for money as such. Sellers of these services could only be completed with stock options as part of the deal. Homes were being sold in Palo Alto for offers consisting of cash plus stock options. Money alone no longer had purchasing power for these goods and services.
In his analysis of Thomas Mann's short story Disorder and Early Sorrow, literary scholar Paul Cantor focuses upon the distortions in daily life under hyperinflation. Cantor writes,
As [Mann] shows, inflation eats away at more than people's pocketbooks; it fundamentally changes the way they view the world, ultimately weakening even their sense of reality. In short Mann suggests a connection between hyperinflation and what is often called hyperreality.
If modernity is characterized by a loss of the sense of the real, this fact is connected to what has happened to money in the twentieth century. Everything threatens to become unreal once money ceases to be real/p>
Cantor's use of the term hyperreality perfectly captures the disorientation of the 90's landscape. At the height of the boom, it seemed that everyone was becoming wealthy, and the best thing about it was how easy it was. All it took was a goofy idea to secure millions of funding for a dot com start-up. A few months later, the fledgling company could be sold in the IPO market for a mind-boggling sum. Not an entrepreneur? It didn't matter—even rank-and-file employees of large corporations like Cisco were routinely becoming millionaires through corporate stock option grants.
Investment clubs consisting of mid-Western grandmothers were earning upwards of 30% annually on their portfolios, enough (compounded out for a few years more) for the entire middle class of America to retire with just a few more years of compounded returns (and leave large inheritances). Everyone could get rich if they would only quit their job and speculate on stocks.
Consider some of the absurd beliefs that were current at the time: profit does not matter to business firms, only "eyeballs". Business firms with a web site but no clear plan were worth more than established industrial giants. Stocks of companies without earnings, or even cash flows, could be worth anything. In this vast celebration of monetary debasement, it appeared to those somewhat anchored in reality that the world was going mad. As Bill Bonner sarcastically observed, it became "fashionable for the delusional to refer to their fellow lunatics as those who 'get it' and to dismiss everyone else'."3
Money, which gives economic actors the ability to compare alternatives in units of a single measure, makes it possible for an economy to develop a much more sophisticated productive arrangement than would be possible with barter alone. Mises' analysis of the market economy emphasized the calculation process that entrepreneurs perform prior to making investments with a long time horizon. Calculation, in Mises' terms, means the process of comparing alternative investments or consumption decisions in terms of a single number. This number is expressed in monetary units.
The direct exchange of consumer goods and closely related producer goods is, of course, possible; it exists today and did so in the past. However, the exchange of goods of a more remote order presupposes the use of money. The concept of the market as the essence of coordination of all elements of demand and supply, upon which modern theory does and must depend, is unthinkable without the use of money. Only with the use of money is it possible to compare the marginal utility of goods in all alternative employments. Only where money exists can we clearly analyze the difference in value between present and future goods. Only within a money economy can this value difference be comprehended in the abstract and separated from changes in the valuation of individual concrete economic goods. (Mises, The Position of Money Among Economic Goods)
Mises warns us that inflation "disintegrate[s] all currency matters and derange[s] economic calculation". Even a moderate inflation makes productive economic activity more difficult because of the distortions of relative prices. Inflation disrupts this calculation process because rapid changes in the purchasing power of money make comparisons between present and future goods impossible. Hyperinflation makes even the comparison between two present goods nearly impossible because prices and so price ratios are fluctuating so rapidly. And in the final stages, the ability of money to serve as a unit of calculation is destroyed when the money is rejected.
Critics of investor behavior during stock market buying panics are focusing on the over-valuation of shares in relation to the earning power of companies. Investors during the 90s were guilty of irrationality if we look only at the expansion of prices ratios between financial assets and consumption goods that was taking place. But understood as a panic response to the calculational chaos introduced by a rapidly depreciating monetary unit we can see the stock buyers of the 90s in the same boat as the Germans of the Weimar era, trying to spend money rapidly becoming worthless.
While the monetary madness of the 90s gave us hyperinflation in stocks, during the last few years the effects of money printing have been seen more in the housing market. As the stock bubble deranged relative prices between financial assets and consumption goods, the inflation of housing is driving home prices to unsustainable levels relative to wages and prices. Partly by artifice, partly by luck, the effects of an over heated printing press have not been felt full-on in wages and consumption goods. But Al and his band of counterfeiters at the Fed are rapidly running out of asset classes large enough to soak up the flood of greenbacks without setting off a visible inflation. If the dollars start to flow into goods and wages, then Weimar, not Wall St. will be the next destination.
Originally published September 21, 2004.