The Weimar Syndrome


Originally published at King World News.

In the early 1930’s, the US dollar money supply as measured by M3 dropped by approximately 30%.  This deflation, i.e., drop in the quantity of money, was one of the steepest in history.  The purchasing power of the dollar -- until 1933 redeemable into gold and thereafter redeemable into silver -- rose dramatically because less money was in circulation compared to the quantity of goods and services available in commerce.

Today, the Federal Reserve no longer reports M3, which is unfortunate because it eliminates the possibility of accurate historical comparisons.  M3 is estimated by economists by modeling historic trends.  However, these models become less reliable as we move further from February 2006, the date the Federal Reserve stopped reporting M3.  Eurodollars, a major M3 component, is particularly difficult to model.

In any case, much attention is being given to these private estimates, even though the decline in M3 they are reporting stands in marked contrast to M1 and M2.  The Federal Reserve reports that these two money supply measures have grown 7.1% and 1.7% respectively over the past twelve months.  Thus, by these two measures, the dollar is inflating, i.e., the quantity of dollars is expanding -- particularly so for M1 -- relative to the available stock of goods and services being produced in today’s depressed economy.

This inflation is also apparent from market prices.  For example, crude oil prices have more than doubled since their post-Lehman crash low.  More broadly, the price index of 19 commodities compiled by the Commodity Research Bureau is up 46% during this same period, which makes clear there is no deflation.

The ongoing erosion of the purchasing power of the dollar has been masked by wealth destruction as over-priced assets like houses fall back to realistic levels.  This wealth destruction from declining prices feels like deflation, but it is not.  In fact, it is forceful distraction taking our eyes off the real problem, which is that the dollar is approaching hyperinflation

This point is insightfully explained by Murray Rothbard in his excellent book, “The Mystery of Banking”.  In explaining the consequences of the inflation-adjusted money supply, he notes:  “When prices are going up faster than the money supply, the people begin to experience a severe shortage of money, for they now face a shortage of cash balances relative to the much higher price levels. Total cash balances are no longer sufficient to carry transactions at the higher price.”

These circumstances prevail today.  While crude oil prices have doubled and commodity prices have risen 46% since September 2008 as noted above, M1 and M2 during this period have increased only 16.9% and 8.5%.  So the prices of goods and services are rising more rapidly than the increase in the quantity of dollars in circulation.  The resulting “shortage of money” is being widely misinterpreted as deflation, which is exactly what happened in Weimar Germany shortly before the Reichsmark was swooped up in a hyperinflationary whirlwind.  Let’s call it a ‘Havenstein moment’, named after the ill-fated president of the Reichsbank who presided over the destructive hyperinflation that devastated Weimar Germany.

With his usual brilliant insight, Rothbard explains what happens once the “Havenstein moment’ is reached.  There are two alternatives.

If the government tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will eventually be reversed, and prices will fall once more – thus relieving the money shortage by lowering prices. But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to ‘catch up’ to prices, then the country is off to the races.  Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices 'run away'…[i.e., hyperinflate]

Weimar Germany took the second alternative.

The dollar is at a "Havenstein moment."  Will policymakers follow the prudent advice of Murray Rothbard and tighten the federal government’s belt?  Or like Herr Havenstein, will Mr. Bernanke continue to "print"?

Sadly, the Federal Reserve will "print," for one reason.  Despite the noble goals assigned to it in textbooks and offered in Congressional hearings, the Federal Reserve exists for only one reason – to make sure the federal government gets all the dollars it wants to spend.  This reality puts the dollar on a hyperinflationary course.

Following the same path as the Weimar government, spending by the US federal government is out of control, causing it to borrow record amounts.  The money to fund this growing mountain of debt must come from savings or ‘printing’, and the sad fact is that there is not enough accumulated savings in the known universe to satisfy the spending aspirations of Washington’s politicians.  So beyond what it can collect from taxpayers and extract from the world’s savings pool, the dollars the federal government is spending can only come from one place – the ‘printing press’, which in today’s monetary system means bookkeeping entries by the Federal Reserve to create dollars that it deposits into the federal government’s checking account.

The deflation of the 1930’s is not possible for another reason.  Like the Reichsmark, the US dollar is no longer defined as or redeemable into a weight of gold or silver.  When it was on a metal standard, dollars could only be created if there was precious metal in the vault to back the newly issued currency. Today there is no restriction – no external control mechanism – on how many dollars can be created, so expect a flood of them from the Federal Reserve.

As Liaquat Ahamed explains in “Lords of Finance”, Herr Havenstein faced a dilemma.  “Were he to refuse to print the money necessary to finance the [government’s] deficit, he risked causing a sharp rise in interest rates as the government scrambled to borrow from every source.  The mass unemployment that would ensue, he believed, would bring on a domestic economic and political crisis...”  Mr. Bernanke faces the same dilemma, and like Herr Havenstein, he thinks he can save the economy by creating more currency.  Instead, the outcome will be hyperinflation, which not only destroys the currency but also the very economy he set out to save.

The remedy to prepare for this impending destruction of the dollar is simple.  Avoid the dollar as much as practical, and own physical gold and physical silver instead.