EPISODES / WEEKLY COMMENTARY

Steve Hanke: How To Avoid A Hyperinflation

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • May 28 2019
Steve Hanke: How To Avoid A Hyperinflation
David McAlvany Posted on May 28, 2019
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This week economist Steve Hanke of the Johns Hopkins University in Baltimore joins the weekly commentary:

  • “There’s never been a hyperinflation of a commodity backed currency”
  • “Behind all hyperinflation is a massive government deficit”
  • “Gold purchasing power is very stable over the long run”

 

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Steve Hanke: How To Avoid A Hyperinflation
May 29, 2019

“Empirically, the best way to deep six the nonsense of Modern Monetary Theory is just to look at the hyperinflation. They contradict the prescriptive elixir that the modern monetary theorist grasps. They’re telling us, ‘Don’t worry about inflation, it’s never going to happen as long as you’re issuing debt in your own currency. You can control it, and there’s no problem.’ It’s just not true.”

– Steve Hanke

Kevin:There are people who actually are not just practitioners, but they are the key men in certain situations. There is a person that you refer to as the hyperinflation hit man.

David:(laughs)

Kevin:He has had decades of being called on the spot. He’s almost a super hero kind of a guy – when we’ve got a hyperinflation, what do we do? The guy’s name is Dr. Steve Hanke. You’ve been reading his material and you’ve been talking to him when you were in New York. It’s about time we have him on the program.

David:As recently as May 23rdthe Wall Street Journal starts talking about the problems in Turkey. We’ve had 50% inflation per year there. What is the prescription? How do you solve this problem, and how to you do it delicately, geopolitically.

Kevin:Who do you call?

David:From a geopolitical perspective, there are certain things that you can and can’t do, and Steve Hanke gets into the mix in terms of what the possible solutions are. Wall Street Journal editorial, May 23rd, you will see him name and the prescription that he says is necessary at currency board.

What we want to do is look at the disciplines necessary for stable money, and there are points in the historical continuum where money goes crazy – the printing of it, the consequences socially and politically from that. The currency board is one way of bringing back the discipline. Of course, we are in an era that is fiat. We are in an era where all money is free-floating and only has relative values, which means we have basically abandoned disciplines. There are, still, even with that being said, many more disciplines in place with certain currencies than with others.

Kevin:When we look at the definition of hyperinflation in the way Steve Hanke defines it, we have had 58 hyperinflations. He has been called in on a number of them back in the 1990s – Bulgaria, Yugoslavia. He has a lot to say about Zimbabwe and Venezuela. Both of those have been just recently in the last couple of years.

David:I would take the time to look at the CATO working paper, “World Hyperinflations.” Published August 15, 2012, it has been updated. There are a few more data points to include since then. But what you will find in that working paper is a chart which basically shows you all the things that you would want to know – it’s the hyperinflation table Hungary, Zimbabwe, Yugoslavia, Germany, Greece.

And it puts it all in perspective because all of a sudden what we thought was the big deal – Germany 1922-1923, is actually not – nowhere near the worst hyperinflation of our era, and very intriguingly ties in the time required for prices to double to where it is not just a monstrous number that you can’t wrap your mind around in terms of an inflation rate – per month, per year, per day, what have you. But the time required for prices to double – 15 hours, 24 hours, 4 days, 15 days – it’s fascinating to see what the real impact is and to put yourself in the shoes of the person who is experiencing that. Today, it’s the man in Venezuela.

Kevin:And Dr. Hanke has also said there has not been a single hyperinflation when a currency is tied to something stable. I would like to hear, Dave, while you are talking to him, about Modern Monetary Theory, the new way of justifying just printing money out of thin air, and how that might apply to socialism. Look at the French Revolution a couple of hundred years ago. Socialism, the answer, there is a revolution one way or another. You either have a revolution toward liberty or a revolution toward socialism. They are almost always in the same room with a hyperinflation.

David:What sounds out as different in the modern era – 20thcentury, 21stcentury, is that there has been an increased likelihood of hyperinflations, but you are right, there are ideas connected to those countries and the malpractice, if you will, in terms of the handling of the monetary system.

*     *     *

So we begin – Professor Steve Hanke, Professor of Applied Economics at Johns Hopkins University, Senior Fellow at the CATO Institute. Steve, we have been looking forward to this conversation for some time. I met you at the Grants Conference along with Dick Sylla and Russell Napier, and of course Jim Grant and a number of other people. We had some fascinating conversations around the financial markets and some of the key economic variables. We looked at different regions of the world.

You are a Professor of Applied Economics at Johns Hopkins University and a Senior Fellow at the CATO Institute, but what that doesn’t say is what your worldly experience has been. Our conversation today may seem like an adventure travelogue as much as a critical look at the topic of hyperinflation. In my opinion, you have lived an interesting life. Not everybody thinks about inflation. In fact, Keynes said that one in a million understand it, and yet you’re one of the foremost experts on it. I’m curious – what about the topic compels you? Do you have a personal whyin that mix?

Steve: I think any economist is always interested in the two components of nominal GDP growth and one is inflation and the other is real economic growth. You slice and dice nominal GDP and there are just two things in it – inflation and real growth. And people are very interested in that, and in fact, with the original misery index that Art Okun developed for President Johnson you would have a simple gauge to see how things were going in the economy.

The original misery index was that misery was equal to inflation plus unemployment. And unemployment is very connected to the real part of economic growth, so you had inflation and then you had unemployment, which as I say is related to real growth. So it is always part of the picture and people in general, let’s face it, are always interested in the purchasing power of the currency that they happen to be living with.

We live with the dollar, but if you are in some place like Argentina, for example, you pay attention to inflation because you know the purchasing power of the peso is going to be very much affected by the inflation rate. And that inflation rate will be driven by the exchange rate of the peso. The peso gets weak and inflation goes up. That’s the name of the game. And if that happens your purchasing power is reduced. All your plans are related to what is going to be happening with inflation.

David:Well, before we go any further, let’s get your definition, because hyperinflation, depending on how you slice and dice that term, gives you how many instances we have had in history. We tend to think of big bouts of inflation even going back to ancient Greece and Rome, but you have a specific definition which puts us at something like 56 or 58 occurrences in all of time.

Steve:Right. There are now 58 by my count, and I did the world hyperinflation table for the Routledge series. Actually, that is where the world hyperinflation table arose. That table was done for the Routledge Handbook of Major Economic Events in Economic History, which was published in 2013. And then there were 56 that we have documented and since then there have been two more, one in Venezuela and one in Zimbabwe, so there are a total of 58. My definition is that the inflation rate per month must reach 50%. That is kind of the standard convention that economists use.

And since that convention I have added another aspect to it because I can measure these hyperinflations with high-frequency data. I can measure it, actually, every day. So I say 50% per month measured in 30 consecutive days. So for 30 consecutive days if the monthly inflation rate is 50% or more, it qualifies as a hyperinflation for me. So it’s a lot of inflation, and in the press the term is used in kind of a loose way. They’re not very careful. Right now, there is only one hyperinflation in existence and that is in Venezuela where the annual rate of inflation today I just measured as 51,929% per year.

David:Well, we’re doing considerably better since earlier in the year when we were at 165,000% or something like that, so things are getting much better for the Venezuelans.

Steve:Right. It has come down since February. It has come down, but it is still in a big state of hyperinflation.

David:(laughs)

Steve:And it has lasted for 30 months. It’s not a huge hyperinflation. It only ranks 23rdout of the 58, David, but it has lasted a long time. There have only been four hyperinflations that have lasted longer than Venezuela’s 30 months.

David:I spoke with Peter Bernholtz. Of course he was looking at things with a different definition. He describes 30 in his book, Monetary Regimes and Inflation, and again, the count differs by how you define the term and set the parameters. I’d love for you to comment on this, I found it interesting that those 28 or 29 out of 30 took place in a context devoid of gold backing for the currency. Can you explore that factor from your perspective?

Steve:There has never been a hyperinflation, no matter how you define them, that has existed where you had a commodity-backed currency. The earliest recorded one was in France. It started in May of 1795 and ended in November of 1796, and that was with a fiat currency. They went off gold, so there is nothing really to control a printing press, shall we say. The currency that was being printed wasn’t redeemable into gold or any other commodity. So inflation took off and they had a hyperinflation in France in that period of time.

And all of the other ones were the same story. There has never been anything that the currency of issue is redeemable into by way of a commodity, whether gold or silver. Those are the two big ones. They are all fiat currencies with no connection whatever to any kind of commodity.

That gets into another point, David. That is, what really causes a hyperinflation? Well, the first thing is that you don’t have any redemption. There is nothing to back the currency, and that’s in the picture, but the big thing that is in the picture is the fiscal side of the government, the government spending money and the sources of financing they are spending dry up on them, for one reason or another conventionally. Either the tax base is gone or eroded. This was the fall of Communism. This was a big factor in the 1990s. There was a lot of hyperinflation in the 1990s because as these countries transitioned from communism to some sort of market-oriented economy. They didn’t have tax administration because in the communist regimes they didn’t any kind of taxes at all.

So the government didn’t have taxes. What is another source of revenue? The international bond market. Well, with the fall of communism they weren’t in the international bond market so they didn’t have that finance, and the domestic bond markets were very disrupted and limited. And the fourth thing, state-owned enterprises that generate revenue for the government were kaput.

So essentially, they were spending money and that obligation, these governments with all the traditional sources of finance were gone, so they go to the central bank. And they tell the governor of the central bank, and of course with a gun at his head, to turn on the printing presses and supply credit to the government so the government could pay its bills. And that means the money supply starts exploding, and as you know Friedman has told us correctly, inflation is always and everywhere a monetary phenomenon.

Well, it is, ultimately, a monetary phenomenon, but behind this explosion of money that causes the hyperinflation there is a massive unfunded government deficit. And the government deficit is funded by the central bank. So that’s the story. And if the central bank was issuing currency based on gold, you see, they wouldn’t be able to turn on the printing press because they simply would tell the fiscal authorities, “Well, if you want something from us you’ve got to give us gold and we’ll give you currency.”

David:I would love to go to the travelogue section of our conversation, which is, you can comment casually on the fall of communism and how things got catawampus with a number of Eastern European countries, but this is not a merely academic exercise for you. You were there. You were invited in to help. So I wonder if we might head to Yugoslavia and Bulgaria, where you had some experience with the Marković government, and also with the government in Bulgaria.

Then we can switch back to Venezuela and kind of compare and contrast. It sounds like the theme is going to be similar throughout. It is a fiscal issue and the finance of fiscal issues. But tell us about your experience on the ground in Yugoslavia.

Steve:I began the Yugoslav adventure, which was fantastic. In January of 1990 I became the personal advisor to the Vice Premier, Jeffco Pregel, and Pregel was in charge of all the economic reforms at that time. So he was the economic tsar in Yugoslavia. The Marković government was a reform government. This was supposedly going to get Yugoslavia on the market, or away from socialism and toward the free-market economy, the Western kind of economy. The first problem that I faced was that they had an endemic inflation there that the average rate of inflation for the 20 years prior to my arrival was almost 80% per year. There were only two countries in the world with higher inflation rates on average than Yugoslavia. So they had a tremendous problem with inflation. And I proposed a currency board system. I wrote a book on it. The book became very popular. There was wide support for a currency board. Now, that would be a system where the Yugoslav dinar would have been emitted but it would have been a clone of the German deutsche mark. It would have traded at a fixed exchange rate, dinar to deutsche mark, free convertibility, and the dinar would have been backed 100% with deutsche mark reserves, so it would be exactly a clone of the deutsche mark. That’s a currency board.

Things were moving in that direction, but unfortunately, by about May or June of 1991 the civil war started and we had Slovenia and Croatia, of course, peeling out of the Yugloslav Federation and then the whole thing broke up. And then there was the Balkan war with NATO against the rump Yugoslavia and Milošević at the time. And that was the second step in my Yugloslav adventure and it was centered in Bosnia-Herzegovina.

Right after the Balkan wars there was the Dayton Peace Agreement and Article 6 of that agreement specified that Bosnia-Herzegovina for the first six years of its existence had to have a currency board. So at that time I then advised the U.S. government – I was sent over to war-torn Bosnia-Herzegovina to Sarajevo to supervise the installation of a currency board there. And that did work. They issued the convertible mark. The convertible mark was then backed 100% with deutsche mark reserves, traded a fixed exchange rate with the deutsche mark, was a clone of the deutsche mark.

And then the next step was Montenegro. Montenegro remained part of the rump Yugoslavia. In 1999 I became [inaudible] and also the advisor to President Đukanović and the Montenegro part of Yugoslavia, using the Yugoslav dinar, which of course was a lousy currency. It had a huge hyperinflation, by the way, the third highest in the world. In January of 1994, the monthly inflation rate in Yugoslavia was 313 million percent a month, the third-highest one in the world.

So Đukanović decided that he would make the German mark legal tender, and with that, of course, dumped the hapless Yugoslav dinar, which he did in November of 1999. And as they say, the rest is history. Then there was a referendum and Montenegro became independent and subsequently joined NATO. Now, once the deutsche mark switched over to the euro, they use the euro in Montenegro, even though it is not part of the EU or the eurozone normally.

David:When we think of large numbers like the 313 million percent on a monthly inflation, those large numbers make the head spin. Maybe you could bring that to the time required for prices to double. If you’re the consumer and you’re buying a cup of coffee, how long does it take for that cup of coffee to double right in front of you in that kind of environment?

Steve:1.41 days. The prices double, and whatever your currency is, in this case the Yugoslav dinar, would have lost 50% of its purchasing power and be sliced in half. The one inflation right above that, Zimbabwe, peaked in November of 2008 and the daily rate of inflation was 98% so prices were basically doubling every day. And then the big super high one, Hungary, is the highest hyperinflation ever recorded in July of 1946. And there, the daily rate was 207%, so every 15 hours prices were doubling in Hungary.

David:With Zimbabwe it is interesting because you had Mugabe who was over-turning colonial injustice. He was, at least in theory, bringing a piece of heaven to earth, and ends up with an African tragedy. But it happens twice. And what is strange to me is, it is not often that you think about lightning striking twice in the same place, but the Zim dollar hyperinflation has two iterations, and they are both within a decade, right?

Steve:The first one was in 2008, this big super high one. Then there was a more modest hyperinflation in 2017. And that one did Mugabe in. He had been there for over 30 years, but people really threw up their hands and said, “We’re not going to have this again.” So he was set up for the coup that occurred that took him out.

David:Do you think – this is maybe not purely an economic question, but do ideas matter? You have Chavez, you have Mugabe, you have Milošević, you have Maduro. Their commonality is not only in the chaos they created, but maybe in the ideologies they sponsored, as well. What are your thoughts on that? Do ideas matter?

Steve:Well, ideas always matter because ideas are, in fact, what drives public opinion, whether they are good ideas or bad ideas, the public has some idea. There is an idea in the air. And it could be as specific as an ideology, and that could drive, in this case, a tremendous amount of government spending that can’t be financed. That is what you have in Venezuela and that is more or less what you had in Zimbabwe, too. Mugabe was spending like a drunken sailor, and the ideology, as you allude to, was that it was a post-colonial kleptocracy that he was running there.

And in the case of Venezuela you have so-called chavezismo, which is a brand of socialism, that basically bankrupted the company and caused the economy to completely collapse. So there is something idea-wise around that supports the idea of either outright socialism or maybe they want to call it something else, but it is something where the state is controlling everything, for one reason or another. It might not be the communist manifesto. They might not necessarily have Marx by their bed stand, but there will be some nationalistic idea, or post-colonial idea, or revolutionary idea. In France, it was the revolution and they were going to modernize everything.

David:Again, this kind of threads the needle on this issue of whose ideology works. We’re in an age that has many critics of austerity and many proponents of fiscal and monetary activism. How do you sell the currency board idea? I know there are more open minds in the context of financial or currency crisis, but doesn’t anchoring a currency place limits on the political benefits of print and spend inclinations?

Steve:The proof of the pudding is that austerity is what works. Every one of these hyperinflations – and these are extreme cases, these big high inflations, 58 of them – have all been caused because there has been no control over the budget and no way to finance the government expenditures that are taking place. Austerity implies that you want some kind of balanced budget, and that’s good, and currency boards put a hard budget constraint in the system.

So even if you have lousy institutions and very poor governance, if you can’t go to the central bank and turn on the printing press, which is the case with a currency board, then you have a hard budget constraint and you have discipline in the system. And that is why places like, for example – how did Lee Kuan Yew start things out in 1965 in Singapore, one of the poorest places in the world in 1965? Now it’s one of the richest places in the world. They started with a currency board. They had a hard budget constraint. That was part of the program.

The other part of the program is that they weren’t going to accept any foreign aid. The other part of the program, and they were going to have first-world highly competitive industries, so they had to have open trade. They had to compete. If they couldn’t compete they folded. If they could compete they did very well, which most Singaporean companies did. But Singapore had no natural resources. It had a great harbor, and that’s about the only natural resource there. But they had austerity. They had the hard budget constraint.

You look at all the research, all the studies, and the countries that do well have hard budget constraints and they keep the government spending and budget under control. Hong Kong has a currency board which is one of the great success stories. Even a place like Bulgaria – I put in a currency board in 1997 in Bulgaria – you ask, “How do you sell a currency board?” Well, there it was easy, they were hyperinflating. The inflation rate was 142% per month.

So finally, after I had been trying to get Bulgaria to adopt a currency board since 1990, in 1997 the crisis came and they called me in and we installed a currency board and cut the legs out from under the hyperinflation immediately. And they still have the currency board, and they have one of the lowest debt levels in Europe. The economy does well. It is stable.

David:I think when we talk about deficits and financing deficits using a printing press, that seems to be the ratchet to the next level in an inflation saga. Can you help me with the difference between what is being proposed now as modern monetary theory and the money printing to finance fiscal projects that often enough has led to hyperinflation? It doesn’t seem to me very different – Modern Monetary Theory and the idea that we don’t need budget constraints, we have a printing press, and we can issue debt in our own currency, therefore there are no fiscal constraints. As someone who knows the history of inflation and hyperinflation, how do you respond to the “new-fangled” idea of Modern Monetary Theory?

Steve:Number one, Modern Monetary Theory – the theory, itself, is very fuzzy and confusing and confused, and so forth. So forget about the theory because no one is really interested in the theory. They are interested in the policy prescription that follows, which you just gave, and that is, you can run huge fiscal deficits and as long as you can issue debt – print money, in short, issue credit from a central bank, and it is denominated in whatever the domestic currency is, you’re okay. If you run into inflation problems all you have to do is just squeeze down the fiscal deficits a little, control that dial, and it will work.

Well, all these hyperinflations, of course, refute, exactly, Modern Monetary Theory. Almost all these countries were issuing credit and debt in their own currencies and running huge fiscal deficit, and as a result they had hyperinflation. Empirically, the best way to deep six the nonsense of Modern Monetary Theory is just to look at the hyperinflation. They contradict the prescriptive elixir that the Modern Monetary Theorists grasp. They are telling us, “Don’t worry about inflation, it’s never going to happen as long as you are issuing debt in your own currency, and you can control it, and there is no problem.” It’s just not true.

David:Transitioning to the debt markets, we’re in an age where credit and the creation of credit is almost indistinguishable from the creation of currency ex nihilo, barely distinguishable. How do you characterize inflation in the money itself versus in money-like instruments?

Steve:Well, I don’t really have a distinction there. Inflation is inflation. You can slice and dice that, there are a million price indices that people use. The easiest one, by the way, is when you get into hyperinflation you can measure it very, very easily by looking at the changes in the exchange rate between whatever the domestic currency is. If we’re in Venezuela you look at the bolivar/dollar exchange rate. I get that every hour, every minute, every day. I use the changes in the exchange rate that have occurred over, let’s say, a year, and then using purchasing power parity theory I can transform those changes in the yearly exchange rate into an annual implied inflation rate for Venezuela.

And that inflation rate covers everything. Everything is covered in that kind of inflation metric. That means commodity prices, prices for services, prices for assets – everything. It is a very broad index, but it turns out it is very accurate. Once you get inflation of about 40% a year you get very accurate measures of these broad inflation figures for a country, and you can do that with high-frequency data. You can measure it every day. And it is very accurate.

David:With the exchange rate being of assistance when you get into that range and the purchasing power parity sort of being the theory behind that, I wonder, when we talk about currencies today, and exchange rates today, we have changed systems. We are in a world of floating, as you said earlier, fiat currencies, and our value is not basis anything absolute, it is all relative currency values.

Does the long-term viability of the currency board change? You choose an anchor, but the anchor, whatever the anchor is, is itself on a slippery slope – maybe not as slippery, but think inflation targeting. You’re still on the gradual downside, depending on the anchor you choose. Ours is 2%, there are other inflation targets of 3% and 6% and 12% around the world. So again, does the long-term viability of the currency board change given that there is no anchor to the anchor, we’re in a floating and fiat system?

Steve:Well, you could make that argument. Some people do. And if you do, the easiest thing is you just anchor it to something else that you think is more stable. Maybe there is a stable basket of commodities that you are going to make the currency board currency redeemable into, or just have a gold-backed currency board. Recently, I have proposed gold-backed currency boards for Turkey, Iran, and Russia, and the reason for that is that there isn’t any political implication or odor associated with anchoring a domestic currency to gold because gold is not produced by a sovereign anyplace. So gold is attractive from that point of view, plus its purchasing power over the long run is, in fact, very stable. The only fiat currency, really – the most stable one is the Swiss franc. The Suisse has actually appreciated, on average since World War I, and in real terms, adjusted for inflation, about 1% per year. So it is an appreciating currency. It is an asset that is appreciating slowly, and it is stable. But it is fiat.

David:So Steve, you said it’s not the rates that matter, it is the broad money that drives nominal GDP. So we’re talking about Volcker, but I do want you to toggle back and forth from the past tense to the present, because we have a president who says we can target 5% GDP and all we need is a little QE. If the Fed would step up and do their job we would get a 5% GDP. What are we talking about here? Is this sane? Is this bordering on a soft version of MMT? Give us some perspective.

Steve:Number one, everyone looks at interest rates and the Fed funds rate. That’s a rate that the Federal Reserve controls, and whether they are going to increase that or decrease it or leave it the same, and so forth, that is what Trump is talking about. He wants them to lower the Federal funds rate. But this is not important. It’s not trivial, but it’s not really the key thing. You have to keep your eye on broad money. The reason you do that is you have to have some model for a national income determination. What drives nominal GDP, in short? Broad money drives nominal GDP. So if broad money growth picks up, nominal GDP will pick up, and if you’re pretty much maxed out at your potential for real economic growth, the increase in nominal GDP will all be in inflation then, in that case.

But what we have is a situation where the Fed is really a small player in the scheme of broad money and producing money. Banks are the elephant in the room. Commercial banks produce about 90% of broad money in the United States measured by what is called the Divisia M4. It’s something produced by the Center for Financial Stability. Bill Barnett is the Divisia M4 guru who has developed this, Professor Barnett, who is a professor at the University of Kansas, as well as a Fellow at the Center for Financial Stability in New York. They produce the data that you need.

The only reliable data, the only measurement that really counts, is Divisia M4, a very broad measure of money. It includes everything that has a lot of moneyness attached to it – even treasury bills, because treasury bills are very liquid. You can convert those into money – cash – easily, and use cash for transactions. It’s not weighted as heavily as cash, but it is given a weight included in the Divisia metric.

And right now that is growing at only 4.4% year-over-year. That’s a pretty slow rate of growth. If the real economy was growing at the high end of where the Trump administration says it could grow – that is 4% – that would mean inflation would only be about half a percent, or something like that. The growth rate is pretty slow right now, so Trump has a point. I think the Fed is too tight. If we look at the rate of growth in broad money, it’s at a fairly low level and has been coming down over the past year to the rate that we have observed recently, 4.4%. So slow broad money growth implies that you are going to have a pretty slow rate of inflation in here.

David:I’m curious what is the most surprising development you have seen in recent years. That is where I would love to finish our conversation today. But you mentioned something in terms of broad money and banks and commercial institutions being responsible for 90% of broad money growth. What impact would there be if you took those excess reserves in depository institutions out from the closet and put them into the economy. What happens with more money sloshing around?

Steve:Well, that’s the key thing. We pay interest on excess reserves right now, and there is a mountain of these excess reserves, of course, because the banks earn interest on them. If the interest rate was dropped and they weren’t receiving any interest, they would have a huge amount of firepower that could back up a lot of credit. And some of that would probably go in the system and you would have a higher rate of money growth. So the key to loosening up is two-fold.

One reason that we have been so tight is that commercial banks, with Basel III and the Dodd-Frank regulations and stricter bank supervision, have been squeezed. So the big elephant in the room has been – it is not so much anymore – constrained, and that is one reason that the great recession lasted so long, because of Dodd-Frank and Basel increasing the capital asset ratios and the capital requirements for banks and squeezing the banks. Once the banks got squeezed, they got a little bit stingy with credit and that huge component of the money supply actually shrank.

So you had a pro-cyclical policy. We go into this shock of a great recession in 2009, and monetary policy actually tightened up tremendously, so you had a very pro-cyclical set of policies that were put into place. And commercial banks, the bank money – you have state money, which is money produced by the Fed, you have bank money, which is money produced by the bank, so the bank money is much, much more important than the state money. But that huge and important component was actually going down. It was declining as the economy went down. And it was due to government policy.

Then the Fed comes in and the Fed says, “Oh, we have to have QE because broad money is going down. We have to do something to mitigate the damage and do something that is counter-cyclical.” And so, if we hadn’t had QE, the money supply would have really gone down and we would have had a huge depression. QE saved us from having a massive depression, given the fact that the government made the mistake of squeezing the banks in the first place.

So you have just a cascading of things happening. You get Dodd-Frank and Basel III, these Basel capital regulations, coming in right when the economy started going into recession. And that is exactly what they shouldn’t have been doing, but they did it, and to mitigate the damage the government had already caused, the Fed then came in with QE, which was fortunate because we would have really been in the soup if the state money component hadn’t increased. So you had the proportion of money being produced by the state actually increase from about 9% to almost 20% at the height of all the QE.

David:This will be challenging. I know I told you I only had one more question. But when you talk about QE being a benefit, I also know just from other things that you have written that you are not a huge fan of monetary policy discretion, some of the benefits of the currency board and anchoring have to deal with removal of discretionary monetary policy. Isn’t it a more elegant solution to not pay interest on excess reserves, allow for credit to flow through the banks, and allow for there to be a natural pricing of debt and liabilities within the marketplace?

Steve:Oh yes, there is no question about it, because there were all kinds of costs associated with QE and running interest rates down to rock bottom levels that they got to because then you had the interest rate prices all distorted, and you had an undue amount of risk-taking associated with that, and mis-valuations of capital because interest rates are used to discount free cash flows and come up with present values of assets.

So if you artificially lower – because that’s what they did, they artificially lowered interest rates – as a result of that, you had an explosion in all kinds of asset prices because the interest rates, meaning the discount rate, went down. And then people couldn’t earn high interest rates, or adequate interest rates, so they started chasing yield and taking more risk than normally they would, trying to reach out for assets that yielded higher interest returns. And on top of that, then they leveraged up, too, so they were going after more risky assets that had higher yield, and to goose it a little bit they would leverage.

And so you had a lot of excessive risk-taking, I would characterize it, as a result of the QE and the low interest rate. So in the broad scheme of things, QE mitigated the damage that the government had already done with bank regulations and so forth. It would have been all much, much worse without QE, but QE also came with many costs associated with it, and the distortion of interest rates is one of those. And something that did come along with it was the payment of interest on excess reserves, which we still have.

And unwinding the Fed balance sheet still hasn’t been completely done. That is the reason that we, right now, have this slow monetary broad money growth is because we have experienced over the last year a bit of quantitative tightening, not quantitative easing.

David:Steve, we explored a little bit of your background. You are a different kind of market practitioner, not a bond trader or that kind of market practitioner, but you are getting into the mix of solving problems and moving from theory to practice in terms of public policy prescriptions. So you have an academic approach, but there is a real market evidence of what works and what doesn’t. That is who you are. That is what you have done. What is the most surprising development you have seen in recent years? We’ll end there.

Steve:The one development I will throw into the mix – I’m a trader, and was president of Toronto Trust Argentina and Buenos Aires in 1995 when we were the world’s best performing mutual fund of 79.25% in 1995. And what were we trading? What was I long? I was long one bond, a peso-denominated bond, the sovereign issued by Argentina.

David:A distressed debt play.

Steve:Yes. Well, everyone else was going out of Argentina. I understood the convertibility system that they had, and at that time it happened to be solid, so that was the play. You assumed that the peso would remain hooked at the dollar one-to-one exchange rate, and the debt was selling for peanuts. But the most surprising thing to me, in a way, is how little people actually understand about money, even though we have gone through this huge great recession, quantitative easing, everything is in the paper.

But I guess it comes back to my 95% rule. 95% of what you read in the press or the journals in economics and finance is either wrong or irrelevant. So I guess I’m not surprised that there is so much confusion out there, because I have been a 95% rule person for the better part of 50 years.

David:Well, how little people understand about money. It’s a conversation with practical implications and there is a philosophy, too – what is real money? What is money? How is it used? How is that system potentially abused? We have to continue our conversation another time, and I look forward to it. We will pause here and come back to, maybe the next time you are a, let’s call you the hyperinflation hit man (laughs). Next time you are brought in to solve a messy problem, that’s when we will have you back on the program.

Steve:That will be great, David. I look forward to it.

David:Thank you, Sir. I appreciate your time.

Steve:Thank you.

*     *     *

Kevin:One of my favorite things that Dr. Hanke said, Dave, was, “All hyperinflations – all of them – refute Modern Monetary Theory.” I don’t think you have to say much more than that.

David:Critical in the equation of every hyperinflation is, what happens on the fiscal side? Do you have the ability to finance your spending, and if you can’t, do you just print to continue that? It is interesting to me because when you think of fiscal conservatism sometimes there is this picture of the curmudgeon who says you just need to live within your means. But there is more to the story.

Kevin:He said austerity always works.

David:(laughs).

Kevin:Right?

David:It’s not always popular, but it does always work.

Kevin:Right. I thought it was interesting, too, that he said “The purchasing power of gold, in the long run, is very stable.” That is why he has recommended it to Turkey, Iran, and Russia.

David:What we have really talked about today is Gresham’s Law, bad money driving out good. We’ve talked about human behavior and the choices that individuals, politicians, and policy-makers make, systems that they are willing to abuse, and what is necessary to fix those systems once they are in freefall or collapse.

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