, James Turk Blog: James Turk: The Vicious Cycle That Creates Hyperinflation

Sunday, March 25, 2018

James Turk: The Vicious Cycle That Creates Hyperinflation


As the government’s debt grows, its interest expense burden grows too, unless interest rates decline enough to keep the amount of gross interest relatively stable, like occurred in the above table since the mid-1990s. But growth in debt without declining interest rates perforce must result in a rising interest expense burden. This outcome puts the currency on the road to hyperinflation.

The hyperinflation results from the same insidious process seen time and again. The government does not generate enough revenue to meet its spending aspirations, including the obligation to service its debt. Rather than cut back on spending, it issues more debt.

In normal circumstances, investors purchase the debt, but at some point, demand from investors is satiated. The government then relies upon the banking system to act as a backstop and purchase the debt not taken up by investors.[ix]

As one would expect, different outcomes result from these two different purchasers. Investors do not turn government debt into currency; only banks can do that. Central banks turn government debt into cash-currency, i.e., the paper banknotes that circulate hand-to-hand, which was manifested in the German hyperinflation.

Commercial banks create deposit-currency, which circulates by check, plastic cards, wire transfers and the like through the banking system. As the saying goes, banks create “dollars out of thin air”. Through the magic of bank accounting, a bank purchasing government debt credits the government’s checking account with newly created amounts of currency that the government then spends, which is the process that created the Argentine hyperinflation.

Regardless which of the two types of hyperinflation occurs, they both start when investors are unable or unwilling to purchase more government debt, which results in growing government reliance upon the banking system to give the government the newly created currency that it then spends. Whether cash-currency or deposit-currency, the banks turn government debt into currency the government needs to meet its expenses and keep its head above water, i.e., to maintain the appearance that the government is solvent.

In this way, the government, with the assistance of banks, creates a never-ending vicious cycle of currency debasement when it is borrowing just to meet its ongoing expenses, including paying interest on its ever-growing debt. As the debt grows, interest rates rise, resulting in a greater annual interest expense payment to lenders and an even larger annual deficit, which in turn requires more debt and higher interest rates, thereby repeating the cycle until it invariably spirals out of control in a hyperinflationary currency collapse.

Borrowing to meet operating expenses is never a good idea. A worse idea is borrowing to meet interest payments on existing debt. These bad ideas when applied to government finance are the worst result because government’s today control the process of creating currency. Consequently, they use banks to turn government debt into circulating currency, and when done without end, the government inevitably creates a vicious cycle during which everyone suffers because it leads to hyperinflation and the collapse of the currency.

- Source, James Turk