Inflationary Depressions and The Currency Dynamic
Inflationary depressions are an economic phenomenon that can have devastating consequences for an economy.
They are born out of the interplay between the amount of currency and debt in the economic system.
Below we look into the relationship between currency, debt, and central banks’ role, the balancing act they must perform to stave off economic disasters, and how the currency dynamic can lead to inflationary depressions.
The dynamics of debt and currency in an economic system can show how inflationary depressions arise and how they can potentially be alleviated or even avoided.
Key Takeaways – Inflationary Depressions and The Currency Dynamic
- Inflationary depressions can have devastating consequences for an economy and are born out of the interplay between currency and debt in the economic system.
- Central banks play a critical role in managing the balance between debt and currency to prevent economic disasters, but finding the right balance is a challenging task.
- The dynamics of debt and currency in an economic system can lead to inflationary depressions, and understanding these dynamics is important for mitigating and potentially avoiding financial crises.
The Role of Currency and Debt in the Economy
In any economy, the roles of currency and debt are twofold.
They act as mediums of exchange, enabling transactions, and as stores of value, enabling accumulation and preservation of value over time.
Debt is seen as a promise to pay in a certain type of currency like dollars, euros, yen, or pesos, and it plays an important role in the functioning of the global financial system.
Debt: An Asset and Liability
Debt is one person’s asset and another’s liability.
For the holder of debt assets, they expect to eventually convert these into money and then into goods and services.
As a result, they are conscious of inflation – the rate of loss of purchasing power – relative to the compensation they receive for holding the debt, typically in the form of interest.
The Central Bank’s Role
The central bank of each country has the unique ability to produce the type of money and credit that they control.
For instance, the US Federal Reserve creates dollar-denominated money and credit, while the Bank of Japan issues yen-based money and credit.
Over time, central banks and free-market borrowers and lenders create large piles of debt assets and liabilities through a symbiotic relationship.
The Challenge of Balancing Debt
The bigger these debt piles grow, the more difficult it becomes for central bankers to maintain a balance to prevent these debts from creating issues.
Policymakers, wielding control over monetary and fiscal policies, usually have sufficient power to redistribute these burdens in crisis situations:
- changing the interest rates on the debts
- changing the durations
- changing whose balance sheets their on
- writing them down
But they may not always succeed in striking the right balance.
Growth vs. inflation trade-offs generally tend to become very acute at some point.
Relieving Debt Crises
Typically, central banks alleviate debt crises by “printing” a significant amount of the currency in which the debt is denominated.
However, when the debt is denominated in a foreign currency, this can’t be done in the normal way.
Printing money will cause the exchange rate of the domestic currency to fall relative to the foreign currency.
This worsens the situation and is analogous to a large rise in interest rates.
The Currency Dynamic
If the value of a currency falls in relation to another at a rate greater than the interest rate differential and the rate of inflation, the holder of the debt in the weakening currency incurs a loss.
Example
For example, say someone owns a foreign bond earning them 10% interest per year and it’s funded by their domestic currency that pays 4% per year.
The interest rate differential is 6%, which would be their net nominal gain if nothing happens to the exchange rate.
Let’s say their inflation rate is 3% and the rate of depreciation (of the foreign currency relative to their own) is 8% per year.
In this case, their return is negative-5% (10% yield minus the 4% funding cost minus the 3% inflation rate minus the 8% currency depreciation), assuming no default or credit loss or adverse price fluctuations of the bond itself (i.e., duration risk).
There are also tax considerations (payment of taxes on the nominal gains).
Currency Dynamic
If traders/investors foresee this weakness persisting without being offset by higher interest rates, a dangerous currency dynamic begins to develop.
Holders of debt in the poorly performing currency are incentivized to sell it and shift their assets into another currency or a non-currency store of wealth like gold.
This currency dynamic can lead to inflationary depressions, where there is economic weakness at the same time the currency falls and leads to high inflation.
Capital Outflows and Currency Weakness
Capital tends to flow out of an environment when it’s considered inhospitable due to the existence of debt, economic, or political problems.
This outflow generally leads to significant currency weakness.
Those who fund their activities in the country with the weaker currency by borrowing in the stronger currency see their debt costs surge.
Therefore, countries with severe debt problems, large amounts of debt denominated in foreign currencies, and high dependence on foreign capital typically face significant currency weaknesses.
This currency weakness is what drives inflation during a depression.
How Can Depressions Be Inflationary?
In normal circumstances, inflation is caused by an excess of demand over supply, leading to rising prices.
However, in a depression, the general economic activity is low, and demand is typically reduced.
So, inflation during a depression seems counterintuitive. But when a currency weakens significantly, inflation can occur even in a depression.
When a currency weakens, the value of that currency compared to others drops.
This means it takes more of the weakened currency to buy goods and services from abroad or any commodity priced in a global market (like oil, for example).
Imported goods and commodities thus become more expensive in terms of the local, weakened currency. This leads to an increase in the general price level, causing inflation.
Furthermore, as a currency weakens, investors/traders and individuals might start to expect further currency devaluation.
To protect the value of their assets, they may convert their holdings into other currencies or assets that hold their value better, like gold, land or real estate, financial assets in other currencies, and so on.
This further increases the demand for other currencies and assets, causing the local currency to weaken even more.
In a depression, a central bank might print more money to stimulate the economy, but this also floods the market with more currency, further devaluing it, leading to capital flight, and contributing to inflation.
Therefore, during a depression, a weak currency can be a significant driver of inflation, despite the overall low demand in the economy.
This is a situation that may be referred to as stagflation, a combination of stagnant economic growth and higher inflation, but is generally worse than that.
The Course of Economic Adjustments
This situation typically persists until the currency and debt prices fall enough to make them attractively cheap.
The squeeze ends when the debts are defaulted on or enough money is available to alleviate the squeeze, the debt service requirements are reduced, or the currency depreciates significantly more than inflation picks up.
This makes the country’s assets and items it sells to the world competitively priced, improving its balance of payments.
However, the actual course of these economic adjustments can significantly depend on the political landscape.
If markets are allowed to function freely, the adjustments eventually occur, and the problems get resolved. While these adjustments can create significant economic and financial issues in a widespread way, they are self-correcting mechanisms.
But if the political situation deteriorates to a point where productivity materially worsens, issues can persist for a long time.
When Do Inflationary Depressions Turn into Hyperinflation?
Inflationary depressions can turn into hyperinflation under certain conditions, typically when a country’s central bank continuously and excessively prints money, leading to a rapid and exponential increase in the money supply.
This often occurs when there’s a lack of confidence in the economy and a severe imbalance in the supply and demand of money.
Here’s a more detailed look at the process:
Rapid Increase in Money Supply
Central banks might significantly increase the money supply to stimulate the economy during a depression, pay off national debts, or fund government spending.
If this process continues without restraint, the amount of currency in circulation can rise rapidly.
And it’s not easy to stop printing money during a crisis.
Stopping printing money when capital is flowing out can create an extreme tightness of liquidity and often a deep fall in economic activity.
And the longer the crisis goes on, the more difficult it becomes to stop printing money.
Loss of Confidence
As more money floods into the economy, the value of the currency starts to decrease.
When people and businesses lose confidence in the currency maintaining its value, they try to spend it as quickly as possible, typically on tangible goods or other more stable currencies (i.e., capital flight).
Each spurt of money printing is increasingly transferred to foreign or real assets instead of being spent on goods and services within the domestic economy to boost economic growth.
Supply and Demand Imbalance
The rapid increase in the demand (money and credit) for goods, combined with a decrease in supply (which can be due to factors like decreased productivity or difficulty obtaining raw materials), drives prices up.
Expectations of Inflation
Inflation can become a self-fulfilling prophecy. If people expect prices to rise, they’re more likely to buy goods now rather than wait, further increasing demand and driving prices up.
When all these factors come together, the result can be hyperinflation, which is typically defined as a monthly inflation rate of 50% or more.
Hyperinflation is an extreme economic situation and is relatively rare, but it can be devastating when it occurs, as seen in historical examples like Zimbabwe in the late 2000s or post-WWI Germany.
Once set in motion, hyperinflation can be difficult to control and requires drastic measures to stabilize the economy.
Generally, the currency needs to be phased out and replaced by a new one with a “hard” backing (e.g., currency value backed by gold and/or silver).
This can even involve dollarizing the economy, or replacing the currency with that of a stable country. For example, Ecuador went to the USD in 2000 to control its inflation problems.
FAQs – Inflationary Depressions and The Currency Dynamic
What are the main purposes of currency and debt?
Currency and debt have two main roles: they function as mediums of exchange and as stores of value.
As a medium of exchange, currency facilitates the trade of goods and services, eliminating the need for bartering.
Debt, as a promise to pay a certain amount in the future, facilitates the flow of capital, allowing borrowing and lending to occur.
As stores of value, both currency and debt enable individuals, businesses, and governments to preserve purchasing power over time.
How is debt an asset and a liability?
Debt is an asset to the lender and a liability to the borrower. When a lender loans money, they gain a debt asset.
This asset is the promise by the borrower to repay the loan with interest over time.
Conversely, for the borrower, the same debt is a liability, a financial obligation that must be repaid.
What is the relationship between debt and currency type?
Debt is denominated in a certain type of currency, such as dollars, euro, yen, or pesos.
The holders of debt assets, expecting to convert them into money and then into goods and services down the line, are very aware of the rate of inflation, or the loss of purchasing power, relative to the interest rate they receive for holding the debt.
In cases of foreign debt denominated in another currency, then the exchange rate also matters.
Adverse movements in exchange rates can wipe out any nominal yield gains.
Traders/investors have to consider:
- nominal yield
- inflation rate
- exchange rate fluctuations
- interest rate risk (duration risk)
- credit risk
- taxes
- opportunity cost
Can central banks produce any type of currency?
No, central banks can only produce the type of money and credit that they control.
For instance, the US Federal Reserve creates dollar-denominated money and credit, while the Bank of Japan makes Japanese yen money and credit.
How do central banks and free-market borrowers and lenders interact over time?
Central banks and free-market borrowers and lenders often create increasingly larger piles of debt assets and liabilities over time.
The more substantial these piles, the harder it is for central bankers to balance the forces that might topple them into a deflationary depression (in reserve-currency countries) or an inflationary depression (non-reserve currency countries) on the other.
How do central banks typically alleviate debt crises?
Central banks usually mitigate debt crises by “printing” a large amount of the currency in which the debt is denominated.
While this strategy stimulates spending on investment assets and the economy, it also depreciates the value of the currency, assuming everything else remains equal.
What is a dangerous currency dynamic?
If a currency’s value falls faster than its interest rate, the holder of debt in the weakening currency loses money.
If traders/investors anticipate this weakness to persist without being compensated by higher interest rates, a dangerous currency dynamic develops.
This dynamic is often the cause of inflationary depressions, with holders of debt in the poorly performing currency incentivized to sell it and transfer their assets to a different currency or a non-currency store of value like gold.
What is the role of capital outflows in an inflationary depression?
Capital outflows typically occur when a country’s environment becomes inhospitable due to issues like debt, economic instability, or political problems.
These outflows often significantly weaken the currency, contributing to inflation during a depression.
This effect is compounded when entities that have borrowed in a stronger currency see their debt costs increase, leading to further currency depreciation.
When does the squeeze in a country facing inflationary depression typically end?
The squeeze typically ends when the debts are defaulted on or enough money is created to alleviate the pressure.
Other solutions can include reducing debt service requirements through mechanisms like forbearance or depreciating the currency more than inflation picks up, so the country’s assets and exports become competitively priced, improving its balance of payments.
However, the politics of the situation can greatly influence the course of these adjustments.
If market forces are allowed to operate freely, the problems may eventually resolve.
However, if politics interfere with productivity, creating a downward spiral, the crisis can persist for a long time.
Conclusion
The interplay between debt and currency plays an important role in the economic health of a nation.
Understanding these dynamics can provide insights into managing and potentially preventing financial crises.
However, the economic adjustments needed to alleviate such situations often depend on the political landscape.
While it’s true that if markets are allowed to function freely, adjustments eventually occur, and problems get resolved, political disruption can extend the duration of economic hardship.
Therefore, the importance of sound monetary and fiscal policy in managing these challenges cannot be overstated.
The role of central banks in mitigating these challenges is important, as is the necessity for a stable political environment to allow for necessary economic adjustments.