Recently there has been a lot of talk among analysts and in the blogosphere about whether we are headed for a period of deflation, inflation or possibly even hyperinflation. There are two significant points to note about this discussion: (1) there is no consensus view and (2) has there been a period in recent history when the debate equally includes the prospects for all three (inflation, deflation and hyperinflation)? It’s all very unusual and in my mind points to just how much risk and uncertainty there is out there.
There was a good post on the subject by Ed Harrison at nakedcapitalism, and an interesting discussion in the comments ensued. The post was not in the context of Peak Oil, but Harrison makes two important points. He says the conditions for hyperinflation are:
1) a huge foreign currency obligation and
2) loss of a significant amount of production capacity.
He goes on to a discussion of the Weimar Republic and Zimbabwe. A third condition that many others noted was that for hyperinflation to take hold there needs to be a complete loss of confidence in fiat money.
I’ve been trying to get my head wrapped around this in the context of Peak Oil to understand whether deflation, inflation or possibly hyperinflation are a risk. The conditions for hyperinflation are not close to being present right now – there is generally a glut of productive capacity since economies are operating well below potential output, and many economies, especially the U.S., may be in a Japan-like liquidity trap, which portends deflation risk. Thinking further, however, there may be a path that leads to hyperinflation and there is a significant probability of several highly indebted economies heading down that path. To understand how hyperinflation could take hold, let’s outline the progression of Peak Oil impacts under a worst case scenario:
1) oil prices rise, much as they did in 2008, to a level that induces recessionary conditions;
2) recessionary conditions cause output to fall, oil prices recede as there is temporary slack in the oil market;
3) growth is sluggish, but governments manage to reflate, much as we saw through 2009 and into 2010; developing countries that also experienced a growth slowdown resume their previous pattern of growth; over a period of a year or two global output again puts pressure on the oil market, oil market slack is used up and oil prices once again trend higher;
4) while oil prices are increasing, the oil price level that previously might have caused recession now merely puts a break on growth, so oil prices test and exceed the previous high and continue to increase to a new higher level that does in fact induce recessionary conditions, again producing some slack in the oil market;
5) the process in (4) may repeat once, twice or several times, but each time several things happen:
(i) there is demand destruction – some consumers and businesses give up marginal activities thereby decreasing there use of oil;
(ii) an increasing proportion of GDP is devoted to spending on oil (at $100 per barrel, that’s about 5.4% of global output)
(iii) for net oil importers, increasing amounts of GDP are going towards paying for oil (“oil debt”) and while there is demand destruction there is also a reallocation of GDP towards oil and away from other economic activities – discretionary expenditures suffer;
(iv) there are price increases not only in the oil price, but also in many other goods that will quickly be impacted because oil is a key component in production (food);
(v) industries that produce discretionary products and services suffer – consumers are cutting back expenditures and reallocating to oil; discretionary products and services experience deflation due to excess capacity;
6) the process induces layoffs as businesses cut back, unemployment increases to a new level with each cycle; any slack in the oil market put out by developed countries is taken up by the developing countries, or oil producing countries themselves, whose oil consumption is escalating rapidly (many OPEC producers subsidize gasoline prices, and they would continue to do this in the face of rising oil prices, cushioning their population);
7) the cycle in (4) above reaches a tipping point as the combination of unemployment and bankruptcies stresses the financial sector again, leading to a second phase financial crisis; a range of events could provide the spark – a balance of payments crisis in any of several countries at risk, a crisis of confidence at a major financial institution.
Whether governments could step into the breach and plug the dam again is an open question. I suppose they would try, but governments, particularly western governments, have little room left over to finance another bailout. Even if they are successful a second time, what happens the third time? – it’s clear that both government and consumer debt levels are generally unsustainable. Once confidence in the ability of governments to stem financial crisis is lost, you would have panic in the financial markets. Paper assets (bonds, shares) may not be worth much, but this alone is not sufficient to lead to hyperinflation. Returning to the preconditions for hyperinflation indicated by Harrison, where would the economy be at this point (and I guess I’m asking this question primarily from the point of view of western net oil consuming countries)?:
- is significant external debt present? Even for the U.S., which only has dollar denominated debt, I suggest the answer is yes. How? – the oil debt, while not a debt in the traditional sense, economies are highly leveraged to it and there is no possibility of canceling the debt in the short or medium term
- is there a loss of productive capacity? yes…increasing over time as rising oil prices lead to demand destruction and shuttering of capacity in a range of economic sectors and, the oil supply itself could begin to fall in a Peak Oil scenario (both because depletion rates and because financial crisis leads to curtailed investment in new production capacity) and so oil directly becomes the productive factor in short supply.
Under this scenario it is not difficult to imagine a loss of confidence in fiat currency, the third condition that may be required for hyperinflation. Of course, governments would also have to resort to the printing presses, but this money would have to actually be spent rather than being held as reserves by the banks (if I understand Harrison and various commenters correctly). In a financial crisis governments may just step in directly by making oil purchases, or to meet any number of other government spending requirements, in the face of otherwise falling tax receipts – governments may not want to take such action, but in a crisis events can rapidly overtake. It’s also possible that in these circumstances the velocity of money would increase rapidly (it’s been declining since the GFC), and that could become the spark for hyperinflation.
In a hyperinflation scenario, fiat money is worthless. Hard goods have value. Barter increases rapidly. The financial system is in meltdown. The risk is not that such a scenario will happen, but that it could happen so easily as events become self-fulfilling. And there is not a policy-maker in the world that will talk about it publicly, let alone propose a plan. That’s not surprising, as the consequences seem so dire and potentially farfetched.
I welcome comments and discussion. If you would like to read about what happens in a hyperinflationary economy, check out Post Peak Oil World: A Description, a previous Sticky Feet post that describes the post-Soviet Union and Cuba experience in light of their own Peak Oil experience.
Sticky Feet blog at TrivCap
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