Although many factors helped bring about the worst financial crisis this century, perhaps the most underappreciated was the widespread reliance on bad assumptions.
Many people took it for granted that what had happened many years ago was, well, ancient history; they figured that with all of the regulatory and other backstops in place, any problems that might crop up would be dealt with by authorities in one way or another; they bet the ranch on the view that low-probability events were not worth worrying about.
Even now, mainstream commentators appear to be ruling out developments that don't quite fit with mainstream economic thinking. But as Jordan Roy-Byrne notes in a post at Minyanville, "Hyperinflation Is Fiscal, Not Monetary Phenomenon," "too many analysts believe there has to be some economic demand or some consumption to stimulate inflation or hyperinflation."
I disagree with the views put forth by John Mauldin, Mike Shedlock, and now Jim Rickards, who all focus on velocity and/or bank lending as important causes of hyperinflation.
The reality is that hyperinflation is first and foremost set in motion and driven by a deteriorating fiscal situation. In fact, significant economic weakness and deflation is a precursor to hyperinflation. Too many analysts believe that there has to be some economic demand or some consumption to stimulate inflation or hyperinflation. Printing money to try to stimulate your economy or excessive credit growth is what leads to inflation. Printing money because you're broke and can’t service your debts is what leads to hyperinflation.
Recently Rickards wrote about how a change in velocity can trigger hyperinflation or severe inflation.
At Mises.org, Henry Hazlitt educates us on velocity:
For example, it is frequently said that the value of the dollar depends not merely on the quantity of dollars but on their “velocity of circulation.” Increased “velocity of circulation,” however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall (or, to put it the other way round, of the belief that the price of goods is going to rise). It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on “velocity of circulation” is just another example of the error of substituting dubious mechanical for real psychological reasons.
Indeed! The focus on velocity may have led you astray over the past 10 or 15 years. Take a look at this chart of velocity from Lacy Hunt of Hoisington Investment Management.
As you can see, velocity actually increased during a time of disinflation and has been muted throughout most of the bull market in commodities. Moreover, despite the sharp drop in credit growth and bank lending in the West during recent years, gold and commodities have powered higher. We know gold has made all-time highs against every currency. Yet, take a look at this chart.
Priced in euros and pounds, commodities have rallied back to their 2008 high! Priced against a basket of currencies (example: US$), commodities are 9% below their 2008 peak. Not bad considering the crash in 2008 and ensuing deflationary environment.
Why are gold and commodities performing so well if we're in a deflationary environment? The greater the deflation and the worse the economy gets, the greater the worry about sovereign bankruptcy, which will come via default or hyperinflation.
Certain government bonds are rallying because they're safe havens relative to other government bonds.
The point is, precious metals are outperforming commodities to a lesser extent even without a rise in bank lending, a rise in credit growth, and a rise in velocity. As I already explained, deflationary forces and a weak economy ultimately exacerbate the ability of various governments to service their ongoing and growing debt burdens.
Hyperinflation is a fiscal phenomenon borne out of a bankrupt state that can’t service its debts. Monetization is a trigger while a rise in consumption and velocity is a psychological effect, as Hazlitt notes. After all, if massive inflation is coming, what's the first thing you want to do? You’ll position yourself in hard assets well ahead of thinking “I need to spend now because this money will be worthless later.”