The problem of inflation and how it will end.
Food Inflation Rate in the World's six largest Economies

The problem of inflation and how it will end.

The price of food is rising everywhere. The USA, UK and Germany are reporting that food prices are more than 10% higher than a year ago.

Our governments and their Central Banks are telling us that they plan to bring inflation under control. There are a variety of techniques to do this. None of them are ideal. Examples include:

Wage and Price Controls: Generally this leads to shortages and potentially rationing. Many countries including the USA (1971) and the UK (1966) have tried this.

Subsidies: This is a temporary fix. It massages the official numbers but does not fix the underlying problem.

Higher interest rates: The aim is to slow down the economy, so that there is less buying pressure. In other words, make people poorer, so that they can't afford to buy more expensive goods.

Export controls: By banning the export of certain goods, the government hopes to prevent foreigners from bidding up the price of sensitive goods. This isn't good for the balance of trade, which in turn causes the exchange rate to fall, so that imported goods cost more. (The government can then blame the foreigners for putting the price up.)

In the interest of brevity, I kept the solutions and accompanying problems over-simplified. There are other options open to governments and their Central Banks, all with their pros and cons.

What if the governments fail in their efforts to reign in inflation? It is instructive to read about other countries where inflation took hold, and where it ultimately turned into hyper-inflation.

In the early stages of rising inflation, some people would start to buy goods, earlier than they would otherwise have done. They believed that this would save them money because they expected prices to be higher in the future. This extra buying pressure helped accelerate price rises.

As prices started to rise faster than before, the urge to buy goods became stronger. This would increase to such a point that people would start buying any kind of goods, or anything that they could lay their hands on, even the things they don't need.

As prices rise faster, nobody wants to own the currency. This can lead to a currency crisis as the exchange rate falls. This further increases the price of imported goods.

A common feature of a failing currency or excessive inflation is regime change. Governments and leaders come and go more rapidly. This can be violently (revolution or coup d'état), through the ballot boxes (General Election or Presidential election), or through a legal process, such as impeachment.

Ultimately inflation became such a big problem that the governments or Central Banks were forced into taking drastic action. The proposed solutions often didn't work, or only worked for a short while. Ultimately a working solution is found. Often the solutions involved a lot of financial pain, particularly for those who held cash, deposits or bonds in the high inflation currency.

How does it all end?

There's no perfect answer to the above question. It all depends on the root cause of the inflation in the first place. If rising prices are caused by a temporary state of affairs, causing a reduction in supply, such as an OPEC decision, war, pandemic, drought or other natural disaster, then the end of that situation can allow prices to return to normal.

On the other hand, where inflation is due to excess money supply, it can be more difficult to restore stability. This is particularly the case if the level of government debt is so high that it can no longer be managed except by printing more money, which in turn drives higher inflation.

So what might happen?

Cancel the old currency and issue a new one? The new currency will "wipe the slate clean" (i.e. cancel the government's debts), and come with a promise that the new safeguards will ensure that "this never happens again". The government gets to decide who is entitled to change their old money into the new one, and how much of it you can change. In general the man-in-the-street will be allowed to convert his old money into the new currency. Those with larger balances, foreigners, and bond holders are likely to be restricted at best, or more likely, unable to convert at all.

In 1924 Germany replaced the Papiermark by the Rentenmark, which in turn was replaced by the Reichsmark the same year. Many other countries have replaced their currencies.

Confiscate bank deposits? In 1990, in Brazil, inflation had soared to over 1700%. In an effort to "slay the tiger of inflation with a single bullet" President Mello ordered the confiscation of all bank deposit worth more than $1250. Officially it was treated as an 18 month obligatory "loan" to the government at 5% interest. At the same time the government introduced a new currency (the The "Cruzeiro" - the third Cruzeiro) to replace the "Cruzado Novo". The act impoverished citizens, and caused the worst recession in history. Whilst inflation fell, it was still so rampant that the government had to order price freezes. President Campo was forced to resign 9 months after the confiscation act. By the time the final instalment of the government "loan" was repaid in 1992 the amount was almost worthless.

Fork the currency? In a currency fork, a currency is effectively split into two parallel currencies, with different sets of rules. Since one currency will be seen as more valuable than the other the exchange rate will not be 1:1. There are several historical examples where countries switched from physical metal (gold and silver) money to paper money. The two continued to co-exist but at different values. Historically forks have been used to force paper money (fiat) on the population instead of gold. Generally the fiat turned out to be inflationary. However there is nothing to say that a fork couldn't be used as an attempt to reign in inflation. This may happen with the future issue of CBDCs. The government might mandate that certain transactions must take place in CBDCs (e.g. Salaries, shopping, taxes, etc), but to control inflation, there will be limits on how much of the old currency you can convert into CBDCs at the 1:1 rate. The old currency may still have a use, e.g. for investing, but the exchange rate won't be 1:1.

Substitution? In an extreme inflation situation, nobody will want to transact in the near worthless currency. Instead a foreign currency will start to be used. This happened in Zimbabwe. Of course there is no shortage of people who think that the next currency should be gold, silver, bitcoin, or something backed by commodities. They are all workable ideas, but Central Banks wouldn't like it.

Above you have some possible scenarios. Any of them, or none of them may happen.

Ever since world currencies went into free-float after 1971, we have seen most governments run budget deficits most of the time. Since governments need to spend more than they collect in taxes, they have to borrow the difference. They can borrow from two sources, - the public, (you, me, your pension fund, China etc), or they can borrow from their Central Bank (Bank of England, Federal Reserve, European Central Bank etc). In general they borrow from both.

When the government borrows from the public, it has little immediate effect on the money supply, and thus not so much effect on inflation. They borrow the money from the system (reducing the supply of money), and then immediately spend it (putting the money back into the economy).

Borrowing from the Central Bank, on the other hand, is inflationary. The government prints a 3% bond for 100 billion and hands it to the Central Bank. The Central Bank then prints 100 billion in cash and gives it to the government. The government spends the cash, boosting the economy and the money supply. That's potentially inflationary. In recent years government debt has been increasing.

No alt text provided for this image

The above picture shows the debt-to-GDP of several major economies. If you look at Central Bank Balance Sheets you will see that most of the extra borrowing has been provided by the Central Bank itself. The newly printed money has gone into the economy and largely found its way into financial assets, such as equities.

Nobody can say for sure how this will end (there are some good endings, as well as bad ones). Given the rather high level of Government Debt-to-GDP, the system is rather fragile. A crisis of confidence may develop. At that point the government will be looking for scapegoats. The system will have to be reset and the government will decide who wins and who loses.

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