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Tuesday, September 23, 2014

A MMT View On The Theory Of Hyperinflations

The post "CMMT - Cate's Modern Monetary Theory" (on Seeking Alpha; free registration required) by Vincent Cate attracted a fair number of comments on the Mike Norman Economics web site. In that post, he presents what he calls CMMT - Corrected Modern Monetary Theory - and he argues that this correction allows MMT to explain hyperinflation. One could probably argue that MMT - as well as mainstream economic theory - do not have standard models that deal with hyperinflation. But that is for the same reason that those bodies of thought do not have standard models to estimate the impact of barbarian incursions along the frontier. It is not to say that foreign incursions do not matter - as the Western Roman Empire can attest - but that such an event is not a serious concern for the industrial economies at present.

I will not attempt to deal with the mechanics of Vincent Cate's model. It appears to based on the quantity theory of money, and it is easy for the reader to validate that the quantity theory has little empirical support. Instead, I want to discuss the theory of hyperinflations.

Hyperinflations - Not Just High Inflation

A hyperinflation is not just a high inflation; it is a situation where the price level rises by at least 50% per month. This Wikipedia article offers a good overview, and lists the historical cases. If you look closely, there are no developed countries with free-floating currencies in the list of hyperinflations. This is no accident; there are strong institutional factors in developed countries that prevent hyperinflation. But if you read articles on some corners of the internet or read market commentary, hyperinflation is always on the verge of breaking out.

The extremely high rate of inflation is an extremely important factor in distinguishing a hyperinflation from a mere "high inflation" episode (which many developed countries had in the 1970s). I discuss that point further below.

Is Hyperinflation In A Developed Country Possible?

Various MMT economists have written about hyperinflations, and they have tended to correctly point out that hyperinflation is associated with a country with large foreign currency liabilities and a collapse in its productive capacity. In other words, a hyperinflation is just the death throes of a economy. (Note that although I have MMT leanings, my views are not necessarily 100% aligned with MMT. As such, I am not a "spokesman for MMT".)

I have not seen any MMT economists pursue the line of thought too far, but it would be possible for a developed economy to have a hyperinflation in the absence of a shock which wipes out its productive capacity. However, it would take a huge amount of stupidity as well as the ability to drive economic policies through safeguards that are put into place within representative governments.

For example, assume that I was invited to induce a rapid hyperinflation in Canada for some reason or another, and I was given the constitutional authority to ram through policy changes for all levels of government. But to make it slightly harder, we'll assume that I cannot be too blatant about it (I cannot do something obvious like mail everyone cheques for $1 billion Canadian dollars) and that the Bank of Canada keeps its 2% inflation mandate (so I cannot just wave the inflation expectations magic wand). I would:

  • Abolish all sales taxes and the value-added taxes (called the GST in Canada). They would be replaced by taxes with fixed dollar amounts (such as a 50 cents a litre tax on gasoline).
  • Income tax withholding would be abolished; income taxes would be paid by the middle of the following calendar year.
  • All government payments would be indexed to current official U.S. dollar exchange rate, and the quotes used would be updated as quickly as possible. (If the Canadian dollar somehow strengthened, the indexation factor will not be allowed to drop below 1, to prevent a "hyperdeflation".) Alternatively, payments could be indexed to a commodity, like gold. We cannot use the CPI, as it is not calculated fast enough to get a good hyperinflation going.
  • To get the ball rolling, I would raise unemployment insurance and welfare payments by 10%. 

The end result is that government revenue would be based on essentially fixed taxes, while spending would indexed to the U.S. dollar. The Canadian dollar would drop in response to a larger fiscal deficit, and the indexation would cause those deficits to blow out further. It would end up worthless in a matter of months. Meanwhile, businesses would switch over to using the U.S. dollar as a unit of account. (They would not use gold, as they would need access to U.S.-denominated loans; there is no market for gold-denominated loans.)

[UPDATE: I have made some changes to the above paragraphs to clarify points in response to comments.]

The central bank and the rentier class could attempt to induce a recession to prevent the hyperinflation by raising interest rates. Unfortunately for them, that would just throw more people onto the welfare rolls and increase the amount of interest income for the non-government sector, and the fiscal juggernaut would still roll over them at a later date.

Although the exact steps used could differ, any potential hyperinflation (that did not rely on some external disaster) would probably have to develop in an environment like I described above. Very simply, the automatic stabilisers embedded in the taxation and spending system would have to be deliberately smashed. (Or more accurately, the part of the automatic stabilisers that slow down nominal GDP growth).

A Mainstream View Of Hyperinflation

Within mainstream economic theory, hyperinflations are hard to simulate using workhorse macro models. There are some more specialised models, but those are special cases.

Using the Fiscal Theory Theory of the Price Level as an example, the set of policies I outlined above would imply an "unsustainable" fiscal policy, and the price level would become unbounded ("infinite"). This would happen immediately, and so there would be no hyperinflation to simulate.

Not all DSGE modellers agree with the Fiscal Theory of the Price Level; within those approaches, all that could be said is that the inter-temporal governmental budget constraint (IGBC) was not respected, and there is no solution. There is some loose discussion of "explosive trajectories", which is exactly what a hyperinflation is. My understanding is that such a trajectory is not supposed to happen, so there is not too much of a literature on simulating them.

Although the mainstream approaches do offer a diagnosis for when a hyperinflation can occur (the IGBC is not respected), the condition is too restrictive. For example, take an economy growing at 5% per year indefinitely, with a steady debt-to-GDP ratio and a discount rate of 1%. It does not respect the IGBC, yet there is no reason for a hyperinflation to occur.


I will now circle back to what Modern Monetary Theory (or a Stock-Flow Consistent Model) says. Modern Monetary Theory is partially a mode of analysis, and it also represents advocacy of particular set of policies. The further a set of policies departs from what MMT advocates, the more the results drift from the way a "MMT-compliant" economy would act. You need to take into account how those divergence will affect the economy.

For example, MMT advocates a free-floating currency. You can use some of the insights of MMT to analyse an economy within the Gold Standard, but you need to understand what constraints are added by the Gold Standard. (Note that MMT is built upon a larger body of Post-Keynesian economics, and so "the insights of MMT" I discuss above may have originated from that larger school of thought. Since I am not an economic historian, I am skipping over these distinctions.)

The set of policies I outlined above to induce a hyperinflation is not an area of interest to MMT economists. They amount to deactivating the automatic stabilisers, which is a very bad idea. Since there is no faction calling for such a set of policies in the developed economies, nobody spends any time worrying about simulating their impact.

But if you wanted to build a model of a hyperinflation, the core idea is that you need to have economic agents set prices using a numeraire* that is not the local currency. In my case, agents would set prices in U.S. dollar terms, but the flows are in Canadian dollars. You then need a mechanism to determine the CAD-USD exchange rate. Since exchange rates are set in markets, they are not easily modelled, but you could probably get reasonable results. All then you need to do is drive the price of $1 CAD to USD $0. The price level (in CAD terms) correspondingly goes to infinity. (I am not familiar with the literature, I believe that this is how the special case of hyperinflation is often analysed. The modelling assumptions will presumably differ between the Post-Keynesian and mainstream approaches. The key difference is that in Post-Keynesian models, prices are administered to be at a level above input costs, whereas in mainstream models prices are driven by marginal costs. A mainstream model pricing is less sensitive to the choice of numeraire.)

This mechanism has to be used, as a hyperinflation is not just a high inflation. The reason is that extremely high rates of inflation cannot be dealt with in the same way as what we are used to.

It must be kept in mind that businesses were able to function for some time, despite the hyperinflationary conditions. Businesses cannot survive if their input costs rise too far relative to output prices, and so there is a limitation of divergences amongst relative prices. As a rough estimate, a "sustained" 1% per month would be a practical upper limit (for a few years). In our current environment, overall inflation rises at about 0.2% per month. This means that individual CPI components can diverge widely relative to the aggregate inflation rate.

In a hyperinflation with 50% monthly aggregate inflation, businesses would still have to keep relative prices close to the aggregate. This means that individual prices have to be fairly closely clustered around the very high average inflation rate. Such a level of coordination would be impossible in the absence of an external store of value. What happens is that businesses are forced to use foreign currency prices, which are then translated into the local currency. (Working from memory, the hyperinflation in Germany ceased during the periods when the foreign exchange markets were closed.)

In fact, this is how hyperinflations are measured. It would have been impossible to calculate a CPI under such conditions; instead academics use the value on the foreign exchange market to back out the implied inflation rate.

Therefore, we see that hyperinflations are actually relatively easy to understand: they are a case when transactions and prices become denominated in a foreign currency, and the local currency is at risk of collapse in the foreign exchange market. Keep out of that trap, and hyperinflation will be avoided.


* A numeraire is the unit of account that is embedded in a model. That is, all prices within the model are expressed as a ratio to the commodity that is the numeraire. A typical choice of numeraire is the local currency, but it can be sometimes easier to chose something else.

(c) Brian Romanchuk 2014


  1. The accounting standard for when to use hyperinflation accounting is if there is probably going to be 100% inflation over 3 years. This is the definition used by huge numbers of people. Cagan used 50% per month in the paper he wrote but he even said in the paper it was arbitrary but suited his purposes. He needed to reduce the number of high inflation cased down to a manageable number so he could write a paper. The same phenomenon is going on at 40% per month, 30% per month, 20% per month, or 10% per month. It should have the same name.

    1. Whether or not it is 50% a month or 20% a month is pretty much irrelevent, I agree. But the point is that it needs to to be sustained for a period of time if you want to use a lower threshold. Working from memory, there are lots of incidents where the price level can be shocked by 10% as the result of removing government subsidies on food and gasoline. Nobody would view those large shocks as being "hyperinflation".

      The accounting standard appears to be too loose. That may be needed for the purposes of accounting, but I do not think it would make sense to apply it to places where high inflation has been entrenched. It would diagnose hyperinflation where most observers would just consider it "normal" high inflation.

  2. Hyperinflation is a positive feedback loop, of this much I am sure. Nothing in what you have above explains any positive feedback loop. So I don't think you have a plausible explanation. I have collected many good explanations. See this:

    1. This comment has been removed by a blog administrator.

    2. The positive feedback in my example comes from the indexation of government spending. As CAD weakens, the amount of CAD spending increases, widening the fiscal deficit. The larger deficit weakens the currency further.

      In your analysis, I see almost no mention of the stabilising feedback provided by the tax system, such as value-added text or income taxes. As nominal incomes rise, the tax take rises proportionately. In my scenario, income and VAT were deactivated to eliminate that stabilisation. Meanwhile, government spending is not indexed, or it is indexed with a considerable lag. Lagged indexation may allow for somewhat high inflation, but it will not sustain extremely high inflation rates.

      With the current income tax and VAT systems in place, it would be nearly impossible for a hyperinflation to occur.

    3. In hyperinflation much of the economy becomes "black market" and does not pay taxes. A guy trades some corn he grew for a chicken his friend grew. Neither of them reports the trade to anyone. There is no VAT, no income tax, no social security tax, no sales tax, nothing. When government law says you must use paper money that is losing value fast most people have to ignore the law to be able to feed their families.

      So while you are thinking that taxes are going to increase, as a percentage of the real economy they go down and the real economy is also going down. So what happens to taxes contributes to the push for hyperinflation, it does not act as a stabilizer.

    4. This comment has been removed by a blog administrator.

    5. As Philippe notes, you cannot assume that hyperinflation already exists in order to argue that hyperinflationary conditions will cause the feedback mechanisms to break down.

      We have had periods of high inflation in the developed economies, and tax systems functioned normally. Obviously, fiscal policy was too loose, but the inflation was eventually contained. If inflation causes people to move away from the formal economy, that would reduce demand pressure within the formal economy. If people are busy raising chickens in their back yards, they are eating less food from supermarkets.

      I can imagine a scenario where people "go off the grid", and retreat from the formal economy. This would reduce the productive and taxing power of the formal economy. If policymakers were foolish, this could eventually cause a collapse of the formal economy, which would probably involve a hyperinflation. That said, such a scenario appears remote at present. However, I may write about a possible policy change that could make such a scenario possible.

    6. "As Philippe notes, you cannot assume that hyperinflation already exists in order to argue that hyperinflationary conditions will cause the feedback mechanisms to break down. "

      You are saying that the tax system provides a negative feedback keeping hyperinflation contained. I am explaining why that is not so.

      Even today when your plumber tells you he will give you a 10% discount if you pay cash, what he is really saying is "If I don't have to pay income tax, self employed social security tax, unemployment tax, etc I can save 50% and so will give you 10% off". It is a gradual thing not a sudden change. I know several different people who have gotten paid in bitcoin because they don't think the IRS will be able to tell which numbered account is theirs, so they don't pay taxes.

      People in the US who are getting government support will often work only for cash, since if they had an official job they would not get so much support.

      Here is a quote from the URL below:
      "Across the globe, failing tax-and-spend economies breed gigantic black markets. Italy’s black market supposedly covers some 20 percent of its economy. The same is true in Spain. In Brazil, that statistic may be up to 27.1 percent. In Israel, the statistic could be up to 25 percent. For member countries of the Organisation for Economic Cooperation and Development, 17 percent of national wealth on average is invested in the black market."

    7. Italy inflation rate: -0.1%
      Spain inflation rate: -0.5%
      Israel inflation rate: 0%
      Brazil inflation rate: 6.5%


      Vince, do big numbers scare you?

    8. I live in Qu├ębec, and the tax authorities here have plenty of experience with the underground economy. However, it appears that it is shrinking; technology makes it easier to track things down.

      The ability of "legitimate" businesses to avoid taxes, in particular value-added taxes, is limited. In particular, a value-added tax (VAT) creates a chain of implicated businesses, and if a business does not report a transaction, it has to eat the VAT.

      Yes, it is possible that tax systems can erode. But that would have to happen before the hyperinflation is possible. In order for an inflation to have any legs, workers' paycheques have to rise in order to allow them to buy the more expensive goods. (Otherwise, volumes just fall, and you end up in a recession. This is what happened in the last couple of oil price spikes.) If workers get a raise, their withholding increases, and the tax rate rises progressively. Meanwhile government spending levels are essentially fixed, at least until the next budget round. This means that there is a tightening of fiscal. Unless you somehow think that all of the workers out there have dropped out of payroll withholding, this is not going to change any time soon.

    9. "Yes, it is possible that tax systems can erode. But that would have to happen before the hyperinflation is possible. "

      The thing about feedback loops or death spirals is that small changes feed on each other. You don't need a break in the tax system before prices can start going up. At the same time people are getting out of bonds, prices can start going up, and the tax system can start breaking down. It is not one before the others, they all go at the same time.

  3. "One could probably argue that MMT - as well as mainstream economic theory - do not have standard models that deal with hyperinflation.[]- but that such an event is not a serious concern for the industrial economies at present."

    In science you have theories to make predictions and then test them. The above of not having a theory because you think (without strong theory) that it is not needed right now for 5 of the 240 countries on this planet is a bit funny.

    What you have put forward here does not take into account the possibility of people getting out of bonds as they come due and having a huge increase in the money supply even if government payrolls did not go up. This seems to be the key in most hyperinflations, monetizing a huge debt.

    1. Right now Venezuela, Argentina, Ukraine, and I am sure others are in the feedback loops of high inflation. Economic theorists should ignore these types of cases?

    2. Note that I said "models" and not "theory". The standard models need to be adapted to deal with hyperinflations, and I gave an outline of how it could be done at the end of my post. These adaptations use the existing theory. I do not know whether this has been done by others, nor have I attempted to flesh out the model completely.

      I have limited time, and I only look at the developed economies. There has never been a hyperinflation in an economy with modern institutions that match those of the developed countries. Nor is there any future risk, on any reasonable horizon. I compared the risk of hyperinflation to the risk of barbarian invasions; that was no accident. I think a barbarian invasion is a higher probability event. Correspondingly, I do not spend too much time worrying about hyperinflation models.

    3. On your point about bonds, people cannot just "get out of them". That can happen if there is risk of default; fiat currency issuers that control their central bank have very condiderable power to avoid default.

      And even if the money supply rises, so what? The basic quantity theory of money does no hold.

      In order to get a sustained inflation, wages have to rise. If an employee comes into their boss' office to get a raise "because the money supply went up", most North American bosses in 2014 would just laugh in the employee's face. How do you think that institutional factor is going to disappear? How long would it take?

    4. "On your point about bonds, people cannot just "get out of them". "

      Yes they can. They just wait till they mature or sell them when the central bank is the only one buying. In hyperinflation people "get out of them".

      "And even if the money supply rises, so what?"

      If the money supply in people's hands goes up and the velocity does not go down then you will get inflation. Nobody has ever shown the equation of exchange to not hold.

      "Your Honor, I will show first, that my client never borrowed the Ming vase from the plaintiff; second, that he returned the vase in perfect condition; and third, that the crack was already present when he borrowed it."

  4. Philippe, if you were standing below a steep hill and an expert told you there was a real risk of a landslide today because of heavy rains last night, would you just say, "it is not moving so far" and think nothing of it?

    Also, the Eurozone is just not the normal case where a single government can get full control over the central bank. It may have trouble if there is a breakup, but it does not look like the pattern I am used to.

    The inflation rate in Brazil was recorded at 6.51 percent in August of 2014. Inflation Rate in Brazil averaged 392.75 Percent from 1980 until 2014, reaching an all time high of 6821.31 Percent in April of 1990 and a record low of 1.65 Percent in December of 1998.

    No need to have a theory of high inflation?

  5. "Inflation Rate in Brazil averaged 392.75 Percent from 1980 until 2014"

    What a meaningless average.

    "an expert told you there was a real risk of a landslide today"

    You're not an expert.

    1. The point is that just that the landslide has not moved so far does not mean there is no risk. The same is true of Earthquakes, forest fires, volcanoes, and hyperinflation.

  6. "All then you need to do is drive the price of $1 CAD to USD $0. The price level (in CAD terms) correspondingly goes to infinity."

    Important point here that is often overlooked. The Fed can then just create $1 USD and buy up all the spare $ CAD and just hold it. Essentially that acts like a massive tax.

    And they will do this in support of their US exporters which would suddenly find their Canadian markets disappearing.

    So in addition to all the currency policies, you'd need to ban imports if you really wanted to cause hyperinflation. Otherwise one of the countries that you import from can stop the rot with a push of a keyboard.

    1. Good point; if you have not noticed, I tend to skip over "open economy" considerations.

      But if the Canadian economy was already heavily indexed to the U.S. dollar ("dollarisation" is unfortunately the wrong word), importers and exporters will have less reason to care about the level of the Canadian dollar. How this "U.S. dollarisation" happens is the mystery to be explained; it is clear that this sort of thing is not happening now in the developed economies.

    2. "I tend to skip over "open economy" considerations."

      Most people do. And I understand why you do that. But unfortunately it implies a fixed currency regime across 'The World' as defined within the model.

      That reinforces the idea that the 'external sector' is a magical being that can act with a single mind as either a Deus Ex Machina or a vengeful Old Testament God depending upon the requirements of the author/commentator.

      When in fact it is a set of economies like yours in competition with each other and inductively linked to your in a similar way that the financial and real circuits are inductively linked within a currency area.

      Really we need a 'World' model with a minimum of three (possibly four) interacting floating currency areas within it - each with a domestic and government sectors. Then everybody has an alternative and the feedback effects across areas are clear.

  7. "On your point about bonds, people cannot just "get out of them"."

    Many of the bonds are 3 month bonds, 6 month bonds, 1 year, 2 year. As these mature their owners can "get out of them" by just not "rolling them over". If after 3 months they get their cash and don't buy a new bond, they are out.

    If the central bank is pegging interest rates at 0.5% then it means they buy all bonds over a certain price, so you can sell your bonds if the central bank is doing this. It seems all major central banks are buying bonds like crazy at the moment. So the public can get out this way too.

    "And even if the money supply rises, so what? The basic quantity theory of money does no hold."

    Do you think anyone has every shown the equation of exchange to not match reality?

    1. If bonds are not rolled over, they end up as excess reserves in the banking system. Banks will always replace those reserves with 3-month T-Bills as long as those T-Bills offer some yield advantage over whatever the central bank pays for excess reserves.

      Your scenarios are reliant upon the governing elites in the developed economies deciding to allow a hyperinflation to occur. Is such an outcome in the interests of the elites?

      The "equation of exchange" is just the definition of velocity. If velocity is not constant, the equation provides absolutely no predictive power. With the demise of Monetarism, there are no credible. living, economists who believe that velocity is constant. I would recommend downloading the time series for the money supply and GDP from the St. Louis Fed, and you can validate the non-constancy of velocity in a spreadsheet within a matter of minutes.

    2. "Your scenarios are reliant upon the governing elites in the developed economies deciding to allow a hyperinflation to occur. Is such an outcome in the interests of the elites? "

      No, I don't think any elites decided they wanted or even would allow hyperinflation. It is just what happens when a government gets to where M1 and M2 are growing fast and they can not stop them. Look at Japan and tell me how it can avoid M1 and M2 growing really fast over the next couple years as people don't roll over their bonds.

  8. "If bonds are not rolled over, they end up as excess reserves in the banking system. "

    Not true. This is not the only place money from bonds maturing can end up. In the US there was about zero excess reserves until they started paying interest in 2008, yet lots of bonds had matured in the years before this.

    1. ?
      You were arguing that investors would refuse to buy bonds, and so the monetary base rises. If you look at the monetary operations, either excess reserves would be created, or notes and coins would have to be withdrawn from bank vaults. Since very few large investors walk around with billions in notes and coins, the money would have to stay within the banking system as excess reserves.

      The historical US experience is irrelevant to your theory, since investors were rolling over the debt. Which is what is always going to happen, given the incentives within the banking system - banks will roll government paper, even if non-bank investors are not interested.

    2. Not everyone has been rolling over their bonds and the excess reserves where basically zero. Just looking at this data it is clear that your claim that bonds not rolled over end up as excess reserves is clearly false, as there was nothing there.

    3. Vincent,

      If you think that it is necessary that each individual investor roll over their position in order for the government to roll over their debt outstanding, you really need to consult some introductory materials on government finance.

      I do not have time to write 1000 word primers in my comments section. See my article "what is a government bond?" to see my discussion of reserve drains.

    4. You agree that the central bank can buy bonds, right? And you agree that if they do buy bonds whoever they bought the bond from can spend their money anyway they want, right? This is true for a single person who does not roll over their bonds and it is true for the aggregate. As people get out of bonds in a country headed for hyperinflation there is far more money and the velocity also starts going up. Prices start going up. Nobody has ever shown a counterexample to the equation of exchange. This has happened many many times before with countries with central banks and currencies setup the same way as Japan or the United states. There is nothing in the accounting formulas that prevented the previous countries from having hyperinflation so there must not be anything in the accounting formulas that would prevent Japan either. This is the key insight you are missing.

    5. But velocity is not constant! It only appeared constant because of stock-flow norms. The bigger your nominal income, the more money you hold. But the causality goes from income to money, not money to income. An exchange of base money for a bond is just a relabelling of government liabilities. If ownership of government liabilities "caused" inflation, there would be a steady "velocity" relationship between incomes and aggregate government liabilities. We do not see anything like that.

  9. Now that Venezuela has hyperinflation, do you use the "no true Scotsman fallacy" to say Venezuela was not a developed country and that is why it can get hyperinflation?

    1. Well, no bond investor would ever consider Venezuela a developed country. It is not a member of the OECD, which is one criteria for being "developed" (although Turkey is in there, which might be viewed as an exception).

      Last I checked, the Venezuelan government is entirely dependent upon oil revenues, and lacks strong tax collection abilities. That is why they could go into hyperinflation, and countries that I consider to be "developed" do not.

      For example, Japan has a strong tax system, and has avoided hyperinflation -- despite the calls for an imminent hyperinflation by some over recent years.


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