The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Will they be able to decrease the huge monetary base they have in time, and raise the interest rate? I expect that this may not be sufficient because of political and psychological pressure on the Fed, and this would mean higher inflation in time in the United States.”
– Peter Bernholz
Kevin: Our guest today is Peter Bernholz. We will be continuing with the question and answer session next week when David returns, but this week David speaks with Peter Bernholz, Professor Emeritus of Economics for the Center of Economics and Business, in Basel, Switzerland. Peter is best known for the book that he has written on monetary regimes and inflation, which analyzes the 29 hyperinflations in world history. Strangely enough, 28 of the 29 hyperinflations occurred in the 20th century and were brought about mainly because of the removal of the gold discipline from the currency.
We go to that interview now.
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David: Peter Bernholz, we think of inflationary periods, going back to Athens, Rome, and ancient times, and you highlight the fact that the worst inflations occurred only in the 20th century. That needs an explanation, and further exploration.
Peter: Yes. Except for the French hyperinflation at the Great Revolution, but it was also based on pure fiat money. So, it is the first example of what has been happening since the abolishment of the gold standard.
David: And so, it really is an issue of what is backing your money, if there is something backing your money it is much more difficult to inflate, versus without a backing, which is really the context that we have had following 1914, and particularly 1930, there seems to be definitive changes in the trend, almost universally after 1930, but particularly following 1914. First, let’s look at the difference in trajectory for inflation before these timeframes, and then after these dates. Then perhaps we can fast forward to the 1970s, where again, there seemed to be an acceleration of inflation.
Peter: After 1914, and finally, in the big depression of the 1930s, the gold standard was really given up. This means that all the paper money which had before to be exchanged into gold at fixed parity at the wish of the public was given up. And now, we had a weakened gold standard in the renewal after the Second World War by the Bretton Woods system. But this referred only to central banks, which could still change their dollar holdings into gold at a fixed parity with the American treasury. This was limited to central banks. But it was at least a binding condition established again after the Second World War for those countries which joined the Bretton Woods system.
After that, let’s say 1971-1973, we had not even this weak connection to gold. And this meant that each country was able to multiply, if it wanted, its monetary base at its own discretion. I could put it together and say that there is no longer any budgetary restraint to central banks. And actually, one of Hungarian [unclear] pointed out in the 1970s that one of the big weaknesses of the planned economy systems of the socialists is that they had no binding budget restraints for firms, businesses, and so on. And we now have no binding budget constraints for central banks.
David: That is interesting. Essentially, your book points out, all hyperinflations in history, with that one exception, the French, which you mentioned earlier, have occurred after 1914. Mankind is tempted to think that technology and direct management bring about better results. Clearly, this is a case where the world’s money mandarins, with improved technology, might not have made things better at all.
Peter: We have two facts at the moment. The first, I have already pointed out, namely that the central banks are able to increase the monetary base as much as they want, and as long as there is a fixed relationship between the broader money and the monetary base, then the broader money will also increase at the same, or a more rapid, pace. Only if because of expectations, this relationship between the two kinds of money can change as we have it in the present situation, then no inflation may occur.
David: So the central bank, creating money, expanding the monetary base, requires the money multiplier to increase to see money used by the public also increase.
Peter: Yes, the banks are required, of course, and you know it yourself, always to exchange your holdings at the bank in the checking accounts, at the fixed rate, into bank notes, and the bank notes belong to the monetary base. As long as this is the case, the money created by the banks cannot increase more than the monetary base.
David: Tell us more about the inflationary bias of political systems.
Peter: That is the second reason, in fact. I personally have shown that, usually, politicians, and therefore the government, have an inflationary bias, and this is understandable if I speak as a public choice economist, because if you want to deliver good things to people, it is always good to increase, at least in the short term until the next elections, the expenditures more than the tax revenues. This means, of course, that you have a deficit. As long as you can finance the deficit in the financial market, it is okay, but there are certain limits to that. And if these limits are reached, the temptation for governments is great to press the central banks, and often they have the full control of central banks for financing their deficits with the creation of the monetary base.
David: This is a fascinating point. Is the inflationary bias of political systems more or less true in a democracy, or a dictatorship?
Peter: This is true, obviously, for all monetary regimes, even for democracies, even in history before we had this fiat paper money system there had been in England, for instance, some debasement of metallic coins by using less base metal, or whatever it is, and there are examples in history that the public represented in some kinds of parliaments, even if it was not the general parliament at that time, had an agreement with the king that if he stopped inflation, they would agree to an increase of the tax base.
David: That is interesting. Well, this idea of a political business cycle. Can you explain that idea, how that works?
Peter: I should add first that one of the efforts to prevent this political bias working itself out is the creation of independent central banks. If they are really independent, if you have some inflation because of political and psychological pressure on central bankers and their own aims, but this cannot get out of bounds, you see. And now to your question, how do I explain that, yes, it is obvious that politicians are re-elected whenever they can grant some benefits to the public or to special interest groups, and on the other hand, have not to increase taxes, you see. At least, not visible taxes. And as a consequence, it happens very often that a budget deficit occurs. And this is especially the case since the negative consequences of increasing the deficit occur usually only after the next election because we have a time lag there.
David: That’s very fascinating. You have commented that there has never occurred a hyperinflation in history which was not caused by a huge budget deficit. Could you expand on that?
Peter: At least this is true for all the hyperinflations and the very high inflations, and even with the metallic money, the highest inflation they could reach with debasement of the metallic money was during the fourth century, and following, of the Roman Empire, but this amounted, on the average, only to 8% per annum. You couldn’t get more without having fiat money or so.
David: This is very interesting, that there is a limitation to inflation with metallic money, and no limits when you are talking about paper money. You talked about Rome. The low rates of inflation, we are told, which are benign, and in fact, today, the argument amongst economists is that low rates of inflation promote economic growth. Can you comment on the cumulative effect of low rates of inflation? How benign are they?
Peter: It is true that we have a certain positive influence sometimes, especially if it is only a short change that is not permanent, on employment and business activity. But with inflations, at least of more than 10%, it absolutely vanishes and turns around. And also, at the moment we have much discussion of the dangers of inflation and most leading central banks look to have a certain inflation rate target of 2% per annum and I am personally very skeptical about it. For instance, during the gold standard, the price level was kept stable, and this means that because you have sometimes some exuberance, let’s say, economic feelings and some higher growth where the prices increase you also need some periods when you have a slight deflation to get the prices down again, to have this average of the price level not increasing at all.
And this means that we have, from the gold standard, quite a lot of evidence that together with mild inflation we had real economic growth. Therefore the fear, if the expectation is that you have long-term stability of the population, then it is quite clear that mild deflations are not dangerous at all. I have looked into the evidence for Britain, because it was, at that time, the leading power, with the gold standard, and we have quite a number of such developments when benign mild deflation did not prohibit real economic growth.
David: We have, as you say, real concerns amongst central banks today that any sort of deflation emerged, so this target 2% inflation has come to be quite popular. The Romans had, on average, about 4.4% inflation, and on the surface that does not sound that bad, and yet, the cumulative effect, between 238 A.D. and 361 A.D. caused a one million-fold increase in the price of wheat. We in the United States over the last hundred years, have average a CPI increase, a consumer price inflation rate, that has been between 3.5% and 4%, not quite what the Romans had, but still, what most would say is a manageable level.
Peter: Yes, it is manageable, but you have to realize, for instance, if you compare the dollar to the Swiss franc, we had, in former times, a rate of 4.2 Swiss francs for one dollar. Now, the price is below one franc for one dollar. And this means that much damage has been done to people who have saved in terms of dollars. If you have a predictable rate of inflation, let’s say you would have, all the time, 2% inflation per year, and if it could be predicted by everybody, then you would have just an interest rate, taking this into account, and then people would not have any problems.
The only problem would then be, the bonds issued by the government would also have these higher interest rates. But this is not the real story most of the time, because suddenly the government, or the central bank, increases the rate of inflation, as happened before the Volcker reforms in the United States. Then this unexpected thing lowers the public debt of the government, but it also erodes the savings of the public.
David: So again, we find a political bias for inflation helping, essentially, to lower the cost of the burden of debt, with the added cost being subtly a denigration of private savings. Let’s go back to what you commented on, the exchange rate between the dollar and the Swiss franc. We are used to looking at an annual inflation rate, and we do a year-over-year comparison, so compared to last year, this year’s rate of inflation is, let’s call it 2%, or 1.8%, or 2.2%, or whatever it may be. But your reference was interesting, because what you have basically done is rolled the clock back and said, “If we choose a base year and compare where we were years ago to today, you see an over 75% decline in the purchasing power of the dollar.” That’s very significant to a saver, but that certainly is not how inflation is presented today. Can you comment on those year-over-year comparisons versus choosing a base year for comparisons?
Peter: What I can state is that the United States has enjoyed a reasonable rate of growth of real economy GDP. For instance, it has not suffered, really. The inflation may have had some distributional effect, and usually it goes disabling the poorer part of the population because they usually don’t have the knowledge and the possibility to safeguard themselves against inflation. As the wealthier part of the population, whenever it is well informed, can go into good stocks, and other financial instruments, to safeguard their savings. But I should also point out that Switzerland, fortunately for us, has had the lowest long-term inflation since the first world war, of all nations, but our real economy has also been growing satisfactorily. This is not by chance that our per capita income is also rather high.
David: Let’s talk about Switzerland just a moment and then we will come back to your book. It is a unique perspective I think you could bring to the current referendum on gold and an increase in gold backing the Swiss currency. Do you care to comment?
Peter: Yes, I have written on this in the Neue Zürcher Zeitung, the leading newspaper here. Actually, I would not have anything against an increase in the stock of gold with the Swiss National Bank, but the popular initiative which is now at stake, they make one big mistake. They will ask the Swiss National Bank to increase their gold stock to 20% of its reserves, but then it should not be allowed to ever lower the gold which it has bought. This means that whenever the Swiss National Bank would need its reserves for different reasons, it could not reduce its gold stock, and I think this is one of the main weaknesses of this initiative. If it could be made flexible that the Swiss National Bank could look at gold just as a part of its portfolio, as it could take in also, foreign stocks and so forth, then I would be satisfied, but this is not the case.
David: Well, thank you for that. Going back to where we were discussing earlier with the Romans, it was under Diocletian that price controls were implemented. That failed to tame the inflation in the fourth century, and then ultimately the death penalty was introduced. My question is this: When you have a failing system, it is very common to see the bureaucrats in that system, the governing body, if you will, become desperate. This is what you saw in the fourth century in Rome. Are there any limits to what government will do? What are the implications for the individual in the context of a failing system and a full-blown inflation? Are there governmental limits? And what are the implications for individuals?
Peter: Price controls have never been successful in the long run, this is quite obvious, beginning with the price controls by the late Roman Emperor [unclear] to the present, they are very limited. Also, if inflation is high, the governments can do what they want. We have even cases where it was not allowed in high inflations to buy, or even to quote prices in stable money, or to buy foreign money. This was not allowed. But even if you put a death penalty, or as the French did in the Great Revolution, 20 years in chains as the penalty on it, it did not work. In the end, if the inflation is very high, indeed, hyperinflation, then you cannot prevent.
If you do not successful [unclear] reform in the hand, the bad inflating money is perfectly driven out by sound, stable money, as recently happened in the 2007 and 2008 in Zimbabwe, where the inflating money was fully driven out by the dollar and the South African rand. So the governments are limited in what they can do. The same is now the problem in Argentina, where they have also followed again a wrong policy and have not very high inflation, but this is sufficient to be a danger for a fixed exchange rate to the dollar, and this has already broken down. Now they have introduced several exchange controls, but in the long run this will not be working.
David: You have also discussed in your book there being a lag between an increase in the money supply and a subsequent increase in prices. Can you discuss that lag, and is that different than what we discussed earlier, expansion of the monetary base, and ultimately, need the money multiplier to increase money used by the public. Are we talking about two different things?
Peter: At the moment, as I mentioned, the broader money, what we usually call M2 and M3, has not increased too much. Therefore, we have not to expect much of inflation. But this depends, again, on this money multiplier, the relationship of the monetary base to this broader money has very much increased, or vice versa, decreased. And looking at the facts, I have seen about the same, but not to the same degree, to the 1930s Great Depression. But someday this will turn around again because of expectations if the expectations change to normal conditions, and this happens if the real economy picks up, and if inflation expectations become positive, then this money multiplier will go back, probably, to the old level. At least, it has done so after the 1930s.
And this means, then, that slowly, we don’t know at which time because we cannot predict expectations very well, but it means that finally the rate of inflation will go up if you don’t decrease the monetary base in time. This means that you have to increase all the interest in time. And what I suppose might happen, but I am not speaking as a monetary economist, but as a public choice economist, and this is less certain than the former, what could happen is the following, that for instance, in the United States, where the Fed is still leading the whole thing, they have already stopped the increase of the monetary base, as you know, and are considering when to increase interest rates.
But the question is, will they be able to decrease the huge monetary base they have which is quite extraordinary by all historical standards, in time, and raise, in time, the interest rate. I expect that this may not be sufficient because of political and psychological pressure on the Fed, and this would mean that you would be seeing a higher inflation in time in the United States. I usually like to refer to an anecdote which happened in Germany when the Nazis had taken over power. Hitler, the new chancellor, asked an economist in his administration to comment on the fears of bankers and economists that inflation might result if he would increase the monetary base very much. Of course, they use other expressions, but you may allow me to say monetary base.
And then these economists answered, “Herr Hitler, you are now the mightiest man in Germany, but what you are not able to do is to bring about an inflation now.” And this has been exactly our situation. But what happened in Germany then? After five years, the Nazis introduced the first price controls and in the beginning of 1939, the central bank, under the same leader who had formally introduced the expansion of the monetary base, Hjalmar Schacht, wrote a letter to Hitler that with such a fiscal policy, financed by money creation, no stable currency could be preserved. Hitler just dismissed the whole body of the central bankers, and what happened, as you know, during the war the mark went down to zero. In the United States you had a similar, but not so dramatic, situation, with the beginning of the war, at least, the inflation began and this money which had been created, and additionally, further money which was created, resulted in inflation.
David: As a historian of these matters, as someone who has reflected on inflationary dynamics and budget deficits and the causal relationships, the contributory factors, could you reflect with us for a moment?
Peter: The dynamics are the following: In the beginning when the broader money is increased strongly, the population is not aware of what has been happening, except, perhaps, for a few experts. And this means that the money supply is increasing more rapidly than the price level, taking into account the real growth of GDP, which has to be deducted. But as soon as the public realizes, after usually a few years, what is happening, this turns around because the public is fleeing from the money because they realize that it is rapidly losing its value, and then this means that the money supply is lagging behind the development of the price level.
This means that the real stock of money that is the nominal money divided by the price level of the inflating money is decreasing, and at the same time, the people turn also to barter, but mostly they turn to some stable foreign money, and in all hyperinflations and high inflations, the stable foreign money, as I has mentioned before, against all penalties and fines, is then driving out the inflating money. This is the dynamic which is happening.
David: Would you think that these dynamics might be witnessed in future years in places like Japan or the United States?
Peter: I don’t expect for the United States that you will be entering very high inflation, but I expect sizable inflation. Of course, it is very difficult to say anything about the range, but I am also somewhat disquieted that some of my Harvard colleagues already say it would be preferable if we had 4-5% inflation to reduce the debt of the government, and to get the economy moving even faster, and I think this would be a very dangerous development. It might be that you would get 4-5% inflation and then the Fed would probably act against it, but this is speculation, especially since I have to take in the public choice relationships between government Federal Reserve and the influence of the feelings of the public on politics. And that is much more difficult to predict.
David: With a 4-5% rate of inflation, would you agree that inflation expectations amongst the general public would most likely change?
Peter: Yes, they would increase then. And this also makes it much more difficult, and my Harvard colleagues expect to stabilize the inflation, because then the public reacts, of course, by increasing their expenditures. And in the bond market the interest rate will go up because people will not like to take into account the inflation rate, so you have some dynamics developing, and this makes it more difficult for the central bank to stabilize the system.
David: We mentioned earlier this idea of increasing interest rates. From a fiscal standpoint, we already spend about 10% of our revenues here in the United States on interest payments. It seems that there are practical limitations to how much the Fed can increase interest rates.
Peter: Yes, that is exactly why I think that there will be strong pressure by the government on the Fed, not only because of the influence on unemployment, but also because the government deficit, which is very high already, would be increased very much if the real interest rate, that is the interest rate minus inflation, would increase, which would be necessary to stabilize the situation.
David: I must ask this question. You mentioned earlier that you are not as concerned with accelerating inflation in the United States, or very debilitating rates of inflation in the United States, and yet we have very large deficits. We also have direct monetization of our debts, and that is what we witnessed over the last 3-4 years. We are seeing a growing trend of central banks all over the world monetizing debts, whether it is public or private. Does that monetization, at all, concern you, given the historical references where monetization created incredibly high rates of inflation?
Peter: Yes, I have proven in this book, Monetary Regimes and Inflation, that in my view, all hyperinflations, and there are very many other high inflations, have usually been caused by deficits of the government financed by money creation.
David: We have the Japanese now, not only monetizing debt, but taking freshly printed money and putting it directly into the stock market. Can you think of a historical precedent similar to that?
Peter: Japan is a special case. They have increased the money supply very much, indeed, even much more than the United States, which has a record, from all historical perspectives. But Japan, and the government debt is now, I think, 230% of gross domestic product. I don’t see how they can get out of this. And then I was trying again to increase the money supply very much and I cannot believe that there will not be a day of reckoning someday.
David: As an individual, there you live in Basel, Switzerland. Where do you see danger, and opportunity, in the world that we live in?
Peter: I really should not comment on this, but I personally think, if you have very high inflation, then you need gold. That is obvious. In the long run, of course, stocks are doing the same, but during the inflation, itself, they have usually also a depressed value, in real terms, and this is only recovering when the inflation has ended. And also, the same is true very often for housing, land and property, and so on, because the government tends, in such a situation of high inflation, to introduce price controls. l
David: That is, to housing and property, price controls apply.
Peter: Yes. At least, this was the case in many inflations because the politicians are afraid they will lose the voices of people renting their property, and therefore, they want to prevent it, and they introduce price controls. And they have done the same for public transportation and other things, and therefore, the relative prices have been going, usually during inflation, against landed property, at least, buildings where you have many people renting apartments or houses.
David: We have another addition of your book that will be coming out within the next few months, Monetary Regimes and Inflation: History, Economic, and Political Relationships, an excellent book, an absolute must for a library concerned about, or related to, monetary matters, economic matters, political matters. You are adding a chapter to this book, as well as expanding on some of the relationships between central bank money, the monetary base expansion, and the money multiplier.
Peter: This relationship, I am now covering in the beginning with some additional paragraphs, and then also I add a chapter, as I mentioned, Chapter 9, which discusses under which conditions you can have inflation-stable monetary regimes, and under which conditions they are abolished, or at least eroded. And these are usually conditions which I discuss very closely also through history.
David: I believe this is the first book which strongly identifies, argues, and supports the idea of inflationary bias being a part of the political system, and incredibly helpful, incredibly insightful. That, and many other insights that you bring in your book. I would encourage listeners to order a copy. If you want the second edition, wait just a few months. Otherwise, the first edition is just as good. And Peter, thank you very much for the time you have spent with us, as well as the time you have spent understanding these issues.
Peter: Yes. Good afternoon, then. Bye.