HYPERINFLATION ITS MORE THAN JUST A MONETARY PHENOMENON

21 March 2011 by Cullen Roche HYPERINFLATION ITS MORE THAN JUST A MONETARY PHENOMENON Inflation is always and everywhere a monetary phenomenon. Milton Friedman Hyperinflation is poorly understood. As its name might imply, most people believe hyperinflation is merely inflation on steroids. But thats not necessarily accurate. Inflation can and does occur in a perfectly healthy economy. In fact, since 1913 when the Fed was founded inflation in the USA has consistently risen at 3.5% per year on average. One might assume that this means the country has experienced some great injustice, but the truth is that the 1900 s were characterized by the greatest economic expansion and wealth creation the world has ever seen. Despite the common citation that the $USD has lost 90% of its value Americans experienced an unprecedented period of prosperity during this inflation. In fact, the prosperity became so gross in the 1990 s that Americans felt entitled to second homes, second cars, and just about every other luxury good known to man. What has not occurred is hyperinflation, which is a very different animal than inflation. Hyperinflation is a disorderly economic progression that leads to complete psychological rejection of the sovereign currency. Contrary to popular opinion, excessively high deficit spending and exorbitant government debt levels are not the actual cause of a hyperinflation. In most cases they have been the result of other exogenous events such as ceding of monetary sovereignty, war, rampant corruption or regime change. It is these exogenous events that result in the publics rejection of the currency, a collapse in the tax system and the government response of printing more money to fill in the confidence void. Ultimately the confidence void cannot be filled and the currency is fully rejected by the public in the form of hyperinflation. In my treatise on the monetary system I discuss the importance of this unspoken agreement between the private sector and public sector: What backs these notes we created? What gives them value? Ultimately, these notes represent some amount of output and productivity. The notes in and of themselves have

no intrinsic value, but serve as a medium of exchange that allows the citizenry to exchange various goods and services. The willingness of the consumers in the economy to use these notes is entirely dependent on the underlying value of the output and/or productivity and my ability to enforce its usage. The government cannot force its value on its citizens. The value of these notes is ultimately determined by the goods and services that are produced by the citizens and the value that other citizens are willing to pay for these goods and services. Therefore, government has an incentive to promote productive output. Otherwise, they risk devaluing the currency. Paying its citizens to sit at home doing nothing, buy cars they dont need or purchase homes they cant afford are unproductive forms of spending (sound familiar?). If government is corrupt in its spending and becomes an institution that is mismanaged and detracts from the private sectors potential prosperity then it is only right that the citizens revolt, denounce the sovereign currency and demand change. The United States Secret Service was in fact created specifically for this purpose to protect the US Dollar. There is arguably, nothing more important to government stability than maintaining the value and faith in the sovereign currency. As long as an economy is productive, the sovereign nation can enforce the use of said currency, and as long as we dont issue excessive currency there should always be demand for it. In other words, trust in the national currency is safe as long as the rule of law is maintained, corporations are productive and I maintain my ability to tax you. If my government becomes corrupt, spends well in excess of productive capacity or mismanages the economy then there is an increasing chance of currency collapse (hyperinflation). In essence, this occurs when the citizenry lose faith in the sovereign currency and slowly refuse to transact and produce in that currency. The users of the currency can always reject that currency. And I believe they should reject the currency if it is not being utilized in a manner that furthers private sector prosperity. This rejection occurs in the form of a collapse in the tax system. When the sovereign loses the ability to tax the game is up. This occurred in Russia in the 90 s, in several Euro nations in the 1920 s (no, Weimar was not the only country that suffered hyperinflation) and most notably in Zimbabwe in recent years. A Historical Review A quick review of the modern economic cases of hyperinflation show striking similarities. Most notably, they involved war (the losing end of a war), regime change or foreign denominated debt. All resulted in catastrophic hyperinflations.

(Figure 1) But its important to note the cause and effect here. These hyperinflations were not merely monetary events. It was not just high inflation or excessive government spending. It was a full blown rejection of the sovereign currency. This is a dramatically different set of circumstances than a gradual increase in inflation or a consistent inflation. The citizens rejected the currency due to these exogenous events. But why does the hyperinflation occur? As I mentioned above it generally occurs due to extreme exogenous events. Hyperinflations have generally occurred in nations with

rampant corruption, war, productive collapse, or other extreme exogenous factors. The money printing that generally results is not actually the cause of the hyperinflation. It is merely the result of this exogenous event. The Case of Weimar The Weimar Republic is the most notable hyperinflation. But it was not the only case of hyperinflation that occurred in Europe at the time. In fact, several European nations were ravaged by the war, war reparations and regime changes that ensued. In the case of Weimar the country was already in a fragile state after Germany lost WWI. To add insult to this injury the allied nations demanded punitive war reparations resulting in foreign denominated debt. Mises elaborated on the insurmountable pressures this caused for Germany: The German government has no alternative way of covering its reparations obligations. It would have no success if it tried to raise the sums demanded by issuing bonds or raising taxes. Given the way matters currently stand with the German people, a policy of compliance could not count on the stand with the German people, a policy of compliance could not count on the consent of the majority if its economic consequences were clearly understood and they were not deceived as to its costs. Public opinion would turn with elemental force against any government that were to try to fulfill the obligations undertaken toward the Allied Powers completely. (Mises 1923, p. 31) In his excellent book, When Money Dies Adam Fergusson described how hyperinflation is more a psychological event than a purely monetary event: To ascribe the despair entirely to ination would be misleading. Undoubtedly, though, ination aggravated every evil, ruined every chance of national revival or individual success, and produced the conditions in which extremists could raise the mob against the state. It undermined national resolution when simple want might have bolstered it. Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be used. Once no one acknowledged it, the Germans learnt, their paper had no value. The discovery that shattered their society was that the traditional repository of purchasing power had disappeared and that there was no means left of measuring the worth of anything. When life is secure, society acknowledges the value of luxuries, those enjoyments without which life can proceed but which make it much pleasanter. When life is insecure, values change. Without warmth, a roof, or adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are water and air. For the destitute in Germany, whose money had no exchange value, existence came very near these metaphysical conceptions. It had been so in the war. In All Quiet on the Western Front, Mller died and bequeathed me his bootsthe same that he once inherited from Kemmerick. I wear

them, for they t me quite well. After me, Tjaden will get them: I have promised them to him. In the above quote from When Money Dies, Fergusson was describing the depression that arose in the Weimar Republic in the 1920 s when they suffered their hyperinflation. The Weimar Republic was a war torn region with a government in turmoil. Economic upheaval compounded the problems as the war reparations from the Treaty of Versailles and the foreign occupation of the Ruhr placed severe strains on the Republics ability to prudently manage their domestic economy/finances. All of this combined to create a scenario that was highly unusual and combustible. German Financier Carl Melchior nicely summed up the situation in Germany in 1921: We can get through the first two or three years with the aid of foreign loans. By the end of that time foreign nations will have realized that these large payments can only be made by huge German exports and these exports will ruin the trade in England and America so that creditors themselves will come to us to request modification. Melchior was ultimately proven correct as the global economy collapsed in spectacular fashion in the late 20 s. But the hyperinflation was well underway when Melchior spoke these famous words and it was not solely due to the government printing presses, but rather a complex (and unusual) series of events that reduced private sector aggregate demand, shattered the publics faith, led to extreme government intervention in currency markets and ultimately resulted in the failure in the national currency. Severe (and unusual) exogenous circumstances lay the groundwork for the hyperinflation to begin, these severe (and unusual) exogenous circumstances initiate the cycle, severe government ineptitude furthers the hyperinflation, severe public mistrust exacerbates it and government ultimately completes the cycle when they desperately crank the presses in an attempt to flood the market with an unwanted currency. Whats important to note here is that the printing press exacerbates and ends the cycle rather than actually initiate it. What lays the groundwork for the hyperinflation is severe exogenous forces or a highly unusual environment that government responds to ineffectively or inappropriately. So Weimar Republic was not merely a case of money printing gone wild. In fact, it was the regime change, fragile state of mind, foreign denominated debts and productive collapse that resulted in the excessive money printing, collapse in the tax system and hyperinflation. The Case of Zimbabwe The other often cited case of hyperinflation is Zimbabwe. This is another extraordinary circumstance. To call these events rare and severe is a vast understatement. Zimbabwe is an utter economic catastrophe. GDP has declined 40% since 2000, unemployment has risen as high as 95% and hyperininflation has ravaged the country. The issue is far more complex than I have the time or space to deal with here, but in essence, Zimbabwe has proven a highly inefficient and corrupt nation for several

decades. This was another case of fragile emotional state due to rampant government corruption, regime change, productive collapse, foreign denominated debts and an eventual collapse in the tax system. The Mugabe government is one of the most controversial in the world and has proven to be financially incompetent. A former government minister of Rhodesia, Denis Walker nicely summed up the environment in Zimbabwe in 1989: Zimbabwes government, already morally bankrupt, will decline towards economic collapse. Like Melchior before him, he was proven correct. But unlike Germanys war torn economy the Zimbabwean economy is a sad story of centuries of racist regimes followed by incompetent leadership. The situation in Zimbabwe has largely arisen from the controversial land reallocations which sliced up their largest export and domestic form of productivity into the hands of the agriculturally incompetent. As internal production of food collapsed the government was forced to rely on the kindness of strangers. The Grecian beggar thy neighbor policy began as Zimbabwe started to rely on foreign imports of food. Unemployment increased, civil unrest increased and the government lost control of its internal finances and the currency ultimately collapsed as the citizenry voted no confidence in the government currency. Allow me to repeat what I said above: Severe (and unusual) exogenous circumstances lay the groundwork for the hyperinflation to begin, severe (and unusual) exogenous circumstances initiate the cycle, severe government ineptitude furthers the hyperinflation, severe public mistrust exacerbates it and government ultimately completes the cycle when they desperately crank the presses in an attempt to flood the market with an unwanted currency. Whats important to note here is that the printing press exacerbates and ends the cycle rather than actually initiate it. What lays the groundwork for the hyperinflation is severe exogenous forces or a highly unusual environment that government responds to ineffectively or inappropriately. The Cause & Effect What is consistent among cases of hyperinflation is a number of rare exogenous circumstances:
y y y y y y y

A ceding of monetary sovereignty (usually in the form of foreign denominated debt, a currency peg, etc). Extraordinarily unusual social circumstances (war, regime change, etc.). Very low levels of faith in government during regime change (high public mistrust). Ineffective government response or rampant corruption. Combustible political environment. A collapse in the domestic economy. A breakdown in the tax system.

The most notable environments involving hyperinflations are war, regime change, government corruption and a ceding of monetary sovereignty. Wars are particularly disruptive for a society for obvious reasons. Being on the losing end of a war is not only disruptive, but catastrophic. Its not surprising that hyperinflations tend to occur in war torn nations because the tax system tends to fail when the citizens begin to question whether or not their government will exist in the coming years. Civil wars have tended to result in hyperinflation as the tax system collapses and the currency issuer continues to spend to finance their losing cause. The American civil war and the Confederacy is exhibit A. Regime changes are equally disruptive. While they can be highly beneficial in the longrun regime changes have tended to coincide with hyperinflations due to the fact that a new government is greeted with skepticism. The uncertainty in such an environment is extraordinary. This was most notable following WWI when several regime changes in Europe ultimately led to hyperinflations. Rampant government corruption is a highly destructive environment. A currency is based on an agreement between the public and private sector. If one party of this agreement is seen as corrupt the other party is likely to want out of the agreement. Zimbabwe is the modern day poster child of corruption and mismanagement of a domestic economy. A ceding of monetary sovereignty is another primary culprit in hyperinflations. This is generally due to government incompetence (such as the current Euro arrangement), productive collapse or corruption. Notable cases include Argentina, Zimbabwe and the Weimar Republic. A ceding of monetary sovereignty via a pegged currency or accumulation of foreign denominated debt is a sure sign that a government is increasingly unstable and at risk of currency collapse. Is Hyperinflation Coming to the USA? While some of these ingredients exist in the modern day United States (to a very minor degree) I would argue that we are a long long way from experiencing the type of environment and downfall that is consistent with past hyperinflations. The most important aspects of currency collapse simply do not exist in the United States today:
y y

We do not rely on the kindness of strangers (no foreign denominated debt). We are not experiencing any sort of extraordinarily unusual social circumstances or severe exogenous forces (losing war, regime change, government corruption, etc). We are not lacking confidence in the sovereign nation. If there is one thing that Americans are known for it is their resilience and borderline arrogance with regards to the strength of their country. We are not experiencing a collapse in the domestic economy (not yet at least).

In sum, if youre betting on hyperinflation in the USA I believe youre effectively betting on the existence of a highly unusual and severe circumstance that happens to coincide with dependence on foreign denominated debt (of which there is none), an economic collapse in the United States (not happening yet), a dramatic decline in Americans confidence and ultimately the destruction of the worlds reserve currency. I do not believe that the current environment is consistent with the disorderly economic environments that are generally consistent with hyperinflations. Dont get me wrong we have big problems in the USA, but I think they are more manageable than many presume. Could the US government become corrupt and incompetent to the point of resulting in a rejection of the sovereigns currency? Sure, but I dont think thats a very realistic outcome given the current environment. Thus far, markets have tended to agree with this as USA CDS remain among the lowest in the world and bond yields remain near their alltime lows. Conclusion In sum, hyperinflation is not merely high inflation. Hyperinflation is a disorderly economic progression that leads to complete psychological rejection of the sovereign currency. While government debts and deficit spending can exacerbate a hyperinflation they have not generally been the cause of hyperinflation, but rather the result of exogenous events. The excessive and incompetent monetary response is generally the result of severe exogenous forces at work such as war, regime change, corruption, or a ceding of monetary sovereignty.

Billy Blog

Printing money does not cause inflation

A number of readers have written to me asking me to explain why the US government (and any sovereign government) should not learn the lesson of the inflation that was caused by the spending policies of the Confederacy during the 1860s in the US. They have tied this query variously in with the rising budget deficits, the quantitative easing policies of the Bank of England and the US Federal Reserve Bank, and more recently the injection of liquidity by the Bank of Japan as a reaction to their devastating crisis. The proposition presented is simple the Confederacy funded their War effort increasingly by printing paper notes (and ratifying counterfeit notes from the North) and saw runaway inflation as a result. This blog examines that point. What you will learn is that the experience of the Confederate states during the Civil War does not provide an case against the use of fiscal policy or the proposition that sovereign governments should run deficits without issuing debt. The fact is that printing paper notes does not cause

inflation per se. It might under certain circumstances. Those circumstances were in evidence in the Civil Wars years in America. It just happens that the topic was covered in a recent New York Times feature (March 14, 2011) Money for Nothing by Ben Tarnoff. The article focuses on the events that followed the establishment of the ephemeral Southern nation, which began with the secession of South Carolina in December 1860. Six other southern states had joined the rebellion by February 1861. On February 8, 1861, the Provisional Constitution for the Confederate States of America was agreed unanimously. It was based on the existing US Constitution with some key differences not germane to our interest here. On February 18, 1861, Jefferson Davis becomes the provisional president of the Confederate States of America. Article I, Section 6 of the provisional Constitution gave the new country the rights of a sovereign government with currency issuing authority with the relevant clauses being: (1) The Congress shall have power to lay and collect taxes, duties, imposts, and excises for the revenue necessary to pay the debts and carry on the Government of the Confederacy, and all duties, imposts, and excises shall be uniform throughout the States of the Confederacy. (2) To borrow money on the credit of the Confederacy (5) To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures. On April 12, 1861 the new country attacks Fort Sumter and the Civil War formally begins it was all down hill from there for the South. Earlier (March 9, 1861), as Tarnoff notes: the congressmen passed a bill that gave the Confederate treasury the power to print notes. The amount they authorized was relatively small: only $1 million. In the coming months, however, that number would increase dramatically. Over time, Confederate paper currency would outgrow its modest origins in Montgomery and become the Souths single most important source of revenue the financial fuel without which the machinery of its government would cease to function. It would both help and hinder the Confederate war effort, sustaining the South in the short term at the cost of future disaster. So the Confederacy in a few short months had established themselves as a sovereign government with monopoly powers to issue the currency and tax in that currency (thus

generating a demand for it). The problem which emerged, however, was that unlike the Union states which could enforce its taxing powers, the Southern government had great trouble raising revenue from taxation. Its public spending was more substantially matched by printing currency notes than in the Northern states. A definitive research work on the public finances of the era is the book by Donald R. Stabile and Jeffrey A. Cantor (1991) The Public Debt of the United States: An Historical Perspective 1775-1990, Praeger: New York. While it established a currency-issuing monopoly the Confederacy had to immediately use that power to fight a war with its northern neighbours. Wars always challenge the inflation barrier because of the supply-side constraints that emerge as a nation gears for and then prosecutes the war effort. Rationing of real goods and services (that is, a nonmarket allocative system) is a typically used device to overcome the supply shortages. A famous reference about this period is the work by Eugene M. Lerner (1954) The Monetary and Fiscal Programs of the Confederate Government, 1861-65 , Journal of Political Economy, Vol. 62, No. 6, pp.506-522. If you have access to JSTOR the article can be located HERE. Lerner notes that Milton Friedman considered the Civil War to: provide precisely the kind of evidence that we would like to get by critical experiments if we could conduct them Mainstream economists have used the Civil War period as a demonstration of their case against budget deficits. The Southern government tried to exercise their tax authority by collecting in-kind taxes from farmers and businesses. They were easily avoided who as Lerner says: sold their goods (or hid them) before collection time There were other problems with the in-kind impost including rotting, damage and theft of the goods. I liked Lerners account of the way the farmers would avoid the impressments who were lying in wait as the farmers went to market: Frequently, impressment agents waited along well-traveled roads and seized the goods of unlucky farmers who happened along, instead of leaving the highways and impressing more equitably the goods of all producers. Farmers who anticipated impressment soon stopped bringing their goods to market and were discouraged from producing more than enough for their own immediate needs.

So not a very sensible revenue-raising strategy. Lerner notes that: Up to October, 1864, almost 60 per cent of all the money received by the Confederacy had come from the printing press. Less than 5 per cent of its revenue came from taxes. Approximately 30 per cent came from bonds sold to banks, institutions, and private persons and 5 per cent from miscellaneous sources. Lerner reports on a struggle between the Southern nations first Treasury Secretary one Christopher Gustavus Memminger and the politicians. The New York Times article noted above has some nice narrative description of Memminger. He wanted to raise property taxes but the Congress declined to support the suggestion. For those with access to the University of North Carolina you can read all of C.G. Memminger Papers at the library there. The New York Times article says that: Memminger wanted slave-owners to bear the brunt of the taxes After much footdragging, the legislators finally complied in August. They didnt tax one kind of property more than another, however. Instead, they adopted a uniform rate of one-half of one percent. The tax turned out to be a fiasco. Sentiment against it ran high, contributing to delays in collection and resistance among the states. Lerner provided the answer to this impasse in his 1954 article. The Southern states were not only hostile to centralisation and that was one of the reasons for the secession, but more pragmatically they: believed that large tax payments were not necessary. Cotton was to be king; England would soon recognize the new nation and intervene actively; the Yankees would not fight; and military battles would go well for the South. The early stages of the War reinforced these expectations. Memminger is often held out by the mainstream as being aware that printing too much currency is inflationary. There is a famous quotation in Lerners article that is repeatedly used to make this case: Secretary Memminger saw two immediate and indispensable benefits from levying taxes payable in government notes. First, taxes created a demand for the paper issued by the government and gave it value. Since all taxpayers needed the paper, they were willing to exchange goods for it, and the notes circulated as money. Second, to the extent that taxation raised revenue, it reduced the number of new notes that had to be issued.

Memmingers numerous public statements during the war show that he clearly realized that increasing a countrys stock of money much faster than its real income leads to runaway prices. They also show that he believed that a strong tax program lessens the possibility of inflation. My colleague Randy Wray in his Understanding Modern Money book provides his view on this quote. He says that it is clear that Memmingers understanding went far beyond the simple quantity theory of money approach too much money chasing too few goods. Randy Wray says that Memminger understood that the nation needed to impose sufficient tax liabilities to create a demand for the notes so that goods and services would be offered at relatively stable prices. I wont try to interpret what Memminger understood at the time. There is an additional point however. There has to be the capacity as well as the willingness to supply real goods and services in return for government spending. I will come back to that point soon. It is clear that a significant role of taxation and a central proposition of Modern Monetary Theory (MMT) is to create a demand for the currency. In a fiat currency system, taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities. The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the nongovernment sector by government spending. It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program. This insight allows us to see another dimension of taxation which is lost in orthodox analysis. Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the nongovernment sector. The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector. In turn, this transfer facilitates the governments socio-economics program. While real resources are transferred from the non-government sector in the form of goods and

services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities. Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes. In my reading of Memmmingers documents I have never found this level of understanding expressed. But he clearly did realise that taxes created a demand for the paper issued by the government and gave it value (as Lerner notes) so it is possible that he did think in the way that Randy Wray describes. At any rate, the ability to collect the tax revenue was severely constrained by a myriad of factors. The New York Times article said that: Relatively little revenue came into Memmingers coffers The Confederacy had been founded on the principle of the sovereignty of the states; any attempt by the central government to assert itself, even to support a war fought for its survival, would be met with mistrust. This antipathy to taxation and the inefficiency of the Southern tax collection system is very well described in Lerners article cited above. He reports that: Sixty-one million dollars entered the Treasury in the first year of the war, and $1.2 billions by September 30, 1863. Absolutely nothing came from property taxes in the first year, and only $20.8 millions by September 30, 1863. The property tax accounted for only 1.7 per cent of the total revenue received. The first point then is that the Confederacy is not an ideal example to use when challenging the basic precepts of MMT. Yes, it did form a government with a provisional constitution giving it taxing and currency-issuing powers as outlined above. But, the essential characteristic of a modern monetary state (that is, a sovereign government) is that its tax borders are not porous. They must be able to effectively enforce the law which requires all tax liabilities to the state being extinguished in the currency of issue. It is one thing to invoke a law (based on a constitution) giving the state those rights but another thing to effectively enforce the rights. Lerner says that for many reasons poor design, recalcitrant member states, invasion from the North etc:

 it became impossible for the South to collect large amounts of revenue through taxation. It would be wrong to think the problem was a lack of revenue. The problem was that the tax system could not be used as an effective vehicle to transfer private resources into the public domain in return for government spending. Further, it seemed that the tax system undermined the supply of real goods and services. Lerner recounts that Memmingers: The Secretarys real alternatives for raising revenue were floating bonds or printing money. He, therefore, recommended that Congress authorize an 8 per cent bond issue of $50 million payable in any resource which can be made available. On May 16, 1861, Congress authorized bonds to be sold for specie, military stores, or for the proceeds of sales of raw products and manufactured articles. Which meant that the farmers would provide the loan funds upon sale of their produce (for example). The problem was as the NYTs article notes that as the war proceeded unexpected difficulties arose. Lerner wrote: At harvest time, however, the market for exported goods was smaller than had been expected. Southern ports were blockaded. Trading with the enemy was discouraged. A grand design forcing Europe to recognize the Confederacy was afoot, and southerners themselves prevented the export of King Cotton. Consequently, the price of cotton was almost 25 per cent lower in September than it had been in June when the pledges were made. Since the general price index for all commodities rose 27 per cent during this period, the real income of the cotton planters fell sharply. Many who planned to buy bonds when they sold their crops became discontented and, instead of buying bonds, demanded immediate government aid. The pledges were the bond commitments. The NYTs artile says that the Southern economy was agricultural, illiquid The South did have white gold cotton. But the cotton trade fell sharply with the Union naval blockade, proclaimed by Lincoln in April 1861. A self-imposed embargo, devised by Southern leaders in an effort to force Britain to support the Confederacy, further curtailed cotton exports. The obvious fact that emerged (and there is a very interesting discussion of the to and fro with respect to the bond issuance in Lerner) was that the Confederacy had unpaid bills piling up. Lerner says:

Unpaid bills began accumulating on Secretary Memmingers desk before revenue could be raised through tax collections or bond sales. Printing notes was the most expedient way of meeting these obligations, and on March 9, 1861, Congress authorized the issue of treasury notes for such sum or sums as the exigencies of the public service may require, but not to exceed at any one time one million of dollars. During the next four years the Treasury printed over fifteen hundred times this amount. The NYTs article notes that (p)aper money had several advantages. It didnt infringe on the sovereignty of the states. It provided a way to avoid taxes and to compensate for the Confederacys lack of capital And it spared the South the more painful task of building a sound financing structure a task that might require difficult decisions about the Confederate systems shortcomings. The NYTs article concludes that: The value these notes generated couldnt be sustained forever, though. As their quantity grew, so would inflation. As paper came to shoulder the bulk of the Confederacys costs, its inevitable depreciation greatly undermined the Southern effort. The war couldnt be funded on faith alone. It required real revenue, something the deliberately decentralized Confederacy wasnt designed to deliver. It is clear that inflation accelerated in this period (in both the North and the South) and was particulary robust in the South. But this conclusion misses the essential point. It was not a lack of revenue that caused the inflation. It was the inability to control aggregate demand through spending and taxation that was the problem. Confused? It is a subtle but important distinction. As explained above, the levying of the taxes would normally generate a demand for the currency of issue which would manifest in the form of a supply of real goods and services to the state from the private sector in return for spending (to get the currency to pay the taxes). This has nothing to do with the Confederacy needing revenue to spend. They constitutionally gave themselves the right to spend by establishing a fiat currency monetary system. But having an infinite capacity to spend is only part of the capacity to exercise appropriate fiscal policy interventions (which might include prosecuting a war effort). However, to elicit that supply of real goods and services, the government must be able to effectively impose the tax obligations. It is clear that the Confederacy was unable to do that.

The problem was further compounded because even if they could have imposed the obligation effectively there was also the impact of the War on the capacity of the Southern states to produce real goods and services. It wasnt the printing of the currency notes that was the problem. It was the fact that there were not enough real goods and services available for sale in relation to the rate of growth of nominal spending (on the war effort) that was the problem. There were additional issues such as counterfeit notes pushed into the Southern economy by the North and ultimately accepted by the Confederacy as legitimate tender. But the supply problems were endemic. When we teach macroeconomics the development of understandings of both the demandside (spending) and the supply-side (output) is important. The pre-Keynesian macroeconomics largely considered the demand-side to be reactive (Says Law) to supply. This was consistent with the denial that an economy could oversupply and thus experience a demand-deficient slump. You will be familiar with the regular statements that printing money causes it to lose value which is another way of saying causes inflation. Once you understand the components of aggregate demand (spending) household consumption, private investment, government spending, and net exports (exports minus imports) the question to explore is how will the economy react to that nominal spending (that is, money value). So statements like increased budget deficits or an expansion of money will cause inflation have to be analysed in terms of how the supply-side of the economy responds to the increased nominal demand. Any nominal demand acceleration coming up against a supply constraint will be inflationary it is not a unique characteristic of public spending. To explore that question you need to know how the supply-side of the economy responds. There are only three options when the economy receives an increase in nominal aggregate demand (spending):
y y y

Increase real output that is, increase production of real goods and services. Increase prices that is, push up the price level. A mixture of both real output increases and price increases.

If nominal demand expansion continues to be met by the second supply response then we get inflation occurring.

The point is that the Confederate states experienced a sharp decline in output during the Civil War for various reasons. There was a severe drought that damaged agricultural production in 1862. Large losses via waste also plagued farmers because there was not enough labour left behind to harvest the crops or bring them to market. Transportation was severely disrupted by the War (as the Southern railway system was attacked and left in ruin). So food shortages led to price rises. The South also lost its textile manufacturing regions to the North early in the War. Additionally, the South was more backward in terms of industrial development at the onset of the War, partly because of its heavy reliance on slave labour which gave agriculture a bias when investment funds were being allocated. So the capacity to produce non-agricultural goods and services was very limited as the War began. I could further document the supply-side problems of the South, which were particularly acute. The War destroyed capacity yet demanded ever-increasing supplies of real goods and services an inconsistency that led to the inflation. The point is that the economy was not capable of absorbing the rate of growth of nominal demand that was required to prosecute the War effort. This is a common problem in war-torn nations. The problem is not the route that the nominal public demand (spending) enters the economy but the rate of growth of that demand in relation to the capacity of the economy to meet it in real terms (that is, via output increases). Conclusion The experiences of the Confederacy are not evidence that rising budget deficits (or quantitative easing) will be inflationary. They might be but when there are idle resources that want to work and are willing to pay taxes then public spending should always elicit a real response (increased output) rather than a nominal response (increased prices). Please read my blog Zimbabwe for hyperventilators 101 for more discussion on the role that the supply-side plays in an inflationary experience. That is enough for today!

Zimbabwe for hyperventilators 101

Zimbabwe is the new Weimar Republic. Not! Zimbabwe is the front-line evidence that shows that government deficits will generate hyper-inflation. Not! Zimbabwe is the demonstration of the folly of a fiat monetary system. Not! Zimbabwe is an African country with a dysfunctional government. Yes! First we should make sure what we are talking about. The right think that when the workers get a pay rise it is inflation. It is not. The left think that when the corporate sector increase the price of a good or service it is inflation. It is not. It is also not inflation when the exchange rate falls pushing the price of imports up a step. It is also not inflation when the government increases a particular tax (say the GST) by x per cent to some new level. So while a price rise is an essential pre-condition a necessary condition for what we call inflation it is not a sufficient condition. That is, the observation of a price rise will be required to define an episode as being inflationary (at some point) but observing a price rise alone will not be sufficient to categorise the phenomena that you are observing as being an inflationary episode. Inflation is the continous rise in the price level. That is, the price level has to be rising each period that you observe it. So if the price level or a wage level rises by 10 per cent every month, then you have an inflationary episode. In this case, the inflation rate would be considered stable a constant rise per period. If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in month three and so on, then you have accelerating inflation. Alternatively, if the price level was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating inflation. If the price level starts to continuously fall then we call that a deflationary episode. Hyper-inflation is just inflation big-time! So a price rise can become inflation but is not necessarily inflation. Many commentators and economists get this basic understanding wrong often and continually. Second, it also follows that cyclical adjustments in price levels by firms from what they are currently offering at depressed levels of activity to what the price levels that are defined at their normal operating capacity levels are also not sensible to consider as inflation. When the economy is in poor shape, firms cut prices in an attempt to increase capacity utilisation by temporarily suppressing their profit margins and hence maintain market share. As demand conditions become more favourable the firms start increasing the prices they offer until they get back to those levels that offer them the desired rate of return at normal capacity utilisation. Have you tried hiring hotel accommodation recently in the tourist areas? Big discounts are on offer but they will disappear once the economy improves. It is not helpful to call that inflation.

Responsible fiscal practice Now at the risk of repeating myself a million times, this is the macroeconomic sequence that defines responsible fiscal policy practice. This is basic macroeconomics and the debt-deficit-hyperinflation hyperventilating neo-liberal terrorists seem unable to grasp it: 1. The sovereign government, which is not revenue-constrained because it issues the currency, has a responsibility for seeing that the workforce is fully employed. 2. Full employment means less than 2 per cent unemployment, zero underemployment and zero hidden unemployment. 3. The sovereign government can purchase any real good or service that is available for sale in the market at any time. It never has to finance this spending unlike a household which uses the currency issued by the sovereign government. The household always has to finance its spending (as do state and local governments in a federal system). 4. The non-government sector typically decides (in aggregate) to save a propoportion of the income that is flowing to it. This desire to save motivates spending decisions which result in the flow of spending being less than the income produced. If nothing else happened then firms would reduce output and income would fall (as would employment) and households would find they were unable to achieve their desired saving ratio. 5. The government sector must in this situation fill the spending gap left by the nongovernment sectors decision to withdraw some spending (in relation to its income). If the government does increase its net contribution to spending (that is, run a budget deficit) up to the point that total spending now equals total income then firms will realise their planned output sales and retain current employment levels. 6. The government sectors net position (spending minus revenue) is the mirror image of the non-governments net position. So a government surplus is equal $-for-$, cent-forcent to a non-government deficit and vice versa. So if the non-government sector is in surplus (a net saving position) then income adjustments will render the government sector in deficit whether it plans to be in that state or not. If income is falling in fhe face of rising saving behaviour of the non-government sector and that spending gap is not filled by government net spending then the budget deficit will rise (as income adjustments cause tax revenue to fall and welfare payments to rise). You end up with a deficit but the economy is at a much less satisfactory position than would have been the case if the government had have financed the non-government saving desire in the first place and kept employment levels high. So a responsible government will attempt to maintain spending levels sufficient to fill any saving. You will note I have discussed this in broad aggregates (government nongovernment) rather than taking the so-called leakages and injections approach which decomposes the non-government sector into foreign and domestic and considers tax, saving and import leakages against the government spending, investment and export

injections. No particularly interesting things emerge at that level of aggregation which are relevant here. We get all the basic insights by keeping it simple. Getting causality right If we think about the Weimar Republic for a moment, the problems for them began long before the hyperinflation, which really went off in 1923. Following World War I the reparations payments required under the Versailles Treaty squeezed the German government so badly that they eventually defaulted. The Treaty was just a bloody-minded pay-back by the victors of the war and brought so much subsequent grief to the World in the 1939-1945 War that you wonder what was going on in their heads. Anyway, for historians, you will recall that the French and Belgian armies then retaliated after the German default and took over the industrial area of the Ruhr Germanys mining and manufacturing heartland. The Germans, in turn, stopped work and production ground to a halt. The Germans kept paying the workers in local currency despite limited production being possible and you can imagine that nominal demand quickly started to rise relative to real output which was grinding to a halt. The crunch came when the export trade stalled and the only way the German Government could keep paying their treaty obligations etc was to keep spending. The inflation followed. But think carefully about the causality here it was not a normal situation at all where a sovereign government was trying to finance the saving desire of the non-government sector and keep employment and output levels high. I sketched the following simple diagram to give you an idea of what might go on when a severe supply shock (contraction) occurs. It is not perfect but makes the point (you have to impose your own dynamic motion on the chart). The horizontal axis is real output and full-employment potential output is shown by the vertical green line (inferring no biounsustainable production levels!) The vertical axis is spending or demand in real terms. The trick is that the price level is held constant in this diagram. The 45 degree line is the fixed-price aggregate supply curve indicating that firms will supply whatever is demanded at the fixed price up to capacity (Point A). After A, supply capacity would be exhausted and inflation would then enter the picture. The red line (top) which intersects Point A is the aggregate demand line and shows the current state of spending in the economy at different real income levels. It is upward sloping because consumption rises with national income and it is less than 45 degrees because not all income is consumed (some saving). So it is the sum of all demand components (consumption, investment, net exports and government spending). If we assume that shangri la prevails then we are initially at Point A. There will be full capacity output, stable prices, some non-government saving and a budget deficit to match.

Now imagine that some dictator comes along and starts taking land off the original farmers (who were productive) and gives it to those who do not understand how to farm or have no real interest in farming, in this primarily agricultural economy. The potential output would steadily contract and I have shown a particular revised potential line (a contraction of the overall capacity of the economy to produce). If you think about current demand levels in relation to that new dramatically reduced supply potential you quickly see there is a huge excess demand (spending) measured by the gap between Points B and D. But, in fact, as the income levels fall, the economy would actually contract along the top red aggregate demand line (as income falls, so does consumption and saving). At Point C there is still excessive demand (spending) in relation to the new potential capacity. So demand would have to be reduced downward (red line shifting down) until it intersected the new supply constraint at the 45 degree line at Point D. Point C could

theoretically be associated just as much with a budget surplus as a budget deficit that is, you cannot directly implicate the conduct of fiscal policy with the excess spending automatically or even necessarily. The upshot is that the price level would be rising in this economy long before it reached Point D from Point A because of the chronic excess spending relative to the dramatically lower capacity. Zimbabwe The hyperventilators out there in debt-deficit hysteria land have been increasing using Zimbabwe as their modern equivalent of the Weimar Republic and as the front-line attack dog in their squawking campaign to get rid of deficits again. The problem is that they clearly have not read much history nor analysed Zimbabwe very well at all. It is obvious that the nice coloured Zw currency has steadily been debased and replaced by notes with more and more noughts on the end of the 1.

So what went on? The Zimbabwean Government is sovereign in the Zw dollar, although recent decisions to allow US dollars to freely trade within the economy is likely to undermine that sovereignty if tax collections in Zw become difficult to achieve. In the same way that the Treaty of Versailles was directly responsible for the plight that Germany found itself in during the 1920s, the white racist regime that ruled prior to 1980 and which had broken away from the colonial arrangements with Britain, set up the conditions that are now destroying Zimbabwe. White minority rule in Colonial Africa created such an unfair sharing of land between the whites and blacks that a backlash was

always going to occur. The same sort of breakdown will threaten South Africa which is trying to reinvent itself (peacefully) in the post Apartheid era (not very successfully may I add). Whites who constituted 1 per cent of the population owned 70 per cent or more of the productive land. After the civil war of the 1970s and the recognition of independence in 1980s, Mugabes government more or less oversaw relatively improved growth with stable enough inflation outcomes. In this World Bank Report 1995 you see the data shows that the economic performance was variable but reasonable. The economy underwent a severe drought in 1992-93 which pushed the inflation rate up but it soon came back to usual levels. The following graph is of GDP growth since independence in 1980 to 2007 (data from IMF). The performance up until about 2000 provided no sign of the disaster that has followed. GDP growth looked to be like many other nations variable and usually positive except for the harsh drought in 1992-93.

The problems came after 2000 when Mugabe introduced land reforms to speed up the process of equality. It is a vexed issue really the reaction to the stark inequality was understandable but not very sensible in terms of maintaining an economy that could continue to grow and produce at reasonably high levels of output and employment. The revolutionary fighters that gained Zimbabwes freedom from the colonial masters were allowed to just take over productive, white-owned commercial farms which had hitherto fed the population and was the largest employer. So the land reforms were in my view not well implemented but correctly motivated.

Like the allies after Versailles, you sometimes do not get what you wish for. The whites in Zimbabwe had always been reluctant to share with the majority blacks and ultimately reaped the nasty harvest they sowed. From an economic perspective though the farm take over and collapse of food production was catastrophic. Unemployment rose to 80 per cent or more and many of those employed scratch around for a part-time living. So the land reforms represented the first big contraction in potential output. A rapid demand contraction was required but impossible to implement politically given that 45 per cent of the food output capacity was destroyed. The situation then compounded as other other infrastructure was trashed and the constraints flowed through the supply-chain. For example, the National Railways of Zimbabwe (NRZ) has decayed to the point the capacity to transport its mining export output has fallen substantially. In 2007, there was a 57 percent decline in export mineral shipments (see Financial Gazette for various reports etc). Manufacturing was also roped into the malaise. The Confederation of Zimbabwe Industries (CZI) publishes various statistics which report on manufacturing capacity and performance. Manufacturing output fell by 29 per cent in 2005, 18 per cent in 2006 and 28 per cent in 2007. In 2007, only 18.9 per cent of Zimbabwes industrial capacity was being used. This reflected a range of things including raw material shortages. But overall, the manufacturers blamed the central bank for stalling their access to foreign exchange which is needed to buy imported raw materials etc. The Reserve Bank of Zimbabwe is using foreign reserves to import food. So you see the causality chain trash your domestic food supply and then have to rely on imported food, which in turn, squeezes importers of raw materials who cannot get access to foreign exchange. So not only has the agricultural capacity been destroyed, what manufacturing capacity the economy had is being barely utilised. Further, goods and services have also been prevented from flowing in via imports because many importers abandon goods at the border when they are hit by exhorbitant import duties. Taken together, the collapse of production has seen the unemployment rate rise to 80 per cent or more. The rising unemployment has further choked any household income growth and aggregate demand has fallen even further. As a consequence, GDP growth has been contracting at around 7 or 8 per cent per year and the economys potential capacity level has been falling dramatically as investment dries up.

Further, the response of the government to buy political favours by increasing its net spending without adding to productive capacity was always going to generate inflation and then hyperinflation. But while the hyperinflation was almost inevitable it provides no intrinsic case against a government that is sovereign in its own currency and who runs permanent deficits to pursue full employment under the guidelines specified above responsible fiscal management. When you so comprehensively mismanage the supply side of your economy as the Zimbabweans did the only way to avoid inflation is to severely contract real spending to match the new lower capacity. More people would have starved and died than already have if the Government had have cut back that severely. But this disaster has nothing much to do with budget deficits as a means to ensure high levels of employment in a growing economy (where capacity grows over time) where the non-government sector also desires to save. A private sector investment boom would have caused the same outcome both in inflation and the political problems of fighting it. So will the hyperventilators also say we should not have net private investment? The historical context is important to understand because it created the political circumstances which have made the hyperinflation inevitable. But these historical vestiges from the colonial white-rule bear very little relevance to the situation that a modern sophisticated fiat monetary system will face. Conclusion So hyperventilate as you like but Zimbabwe does not make a case against the use of continuous budget deficits in defence of full employment. Bad Governments will wreck any economy if they want to. A wise government using the fiscal capacity provided to it by a fiat monetary system can engender full employment and equity yet also sustain price stability.