Chartalism and Hyperinflation

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Chartalism: or "state theory of money" is a monetary theory based on the
idea that legal restrictions or customs can maintain the value of money,
not intrinsic content of valuable metal.

Money is only a fcilitator of the real productive process. Money is not
a factor of production, neither is it a technological element. Money in
itself and by itself does not generate wealth. That is why an exclusive
change of monetary condition would mean little beyond changing the form
of dealing with the issue of the exchange.  The manipulation of money,
however, is of critical importance to the creation of wealth.

It has been suggested that Chartalism leads inevitably to
hyperinflation.

Milton Friedman (Studies in the Quantity Theory of Money, 1956):
"I shall define Hyperinflations as beginning in the month before the
monthly rise in prices exceeds 50% and as ending in the month before the
monthly rise in prices drops below that amount and stays below for at
least a year."

While Friedman's definition of hyperinflation is useful, his explanation
of it as being caused by too much money is less convincing.
In my view, neither quantity nor velocity of money can explain
hyperinflation which is usually the result of a political decision
rather than a causal phenomenom of economic metabolism.  While there is
an association between the level of money supply and the level of
prices, a causal relations is not at all clear.  The two associated
levels may simply be linked symptoms of the same political decision.
Under the principles of Chartalism, the political authority has the
power to set both the supply of money and the value of money, whetner it
be a regime of fiat money, or specie money or commodity money.  Market
forces can operate only if the political authority chooses to allow them
to operate, and only to the extend envisioned by the political
authority. A fair market itself is fundmentally a political concept.

If hyperinflation is a price-level bubble, then hyperinflation is
possible at any rate of money growth in the context of any theory of
money, since price level bubbles can be caused by a wide range of
factors besides the quantity of money.  One could define the Nasdaq
bubble of the late 90s as hyperinflation.  Money, because of its
liquidity prerequisite, is primarily an instrument for financing
consumption.  Money exists as certificates of debt freely (almost)
circulated and exchanged so that consumption can occur.  Money is a poor
instrument to stimulate supply-side boom.  This is because money is an
inferior financial asset, albeit the most liquid, particularly cash
which is DZM (debt with zero maturity). The decision to accept money
(cash transaction) is a decision to engage in monetary exchange through
an acceptable third party debt certificate (mostly the issuing
goverment, but at times private issuers). A credit line from a
commercial banks is denominated in legal tender for both reasons of law
and reasons of convenience.  Vendor finacing from GE is denominated in
dollars for the same reasons.  It sould be denominated in jet engines,
but it would be a cumbersome transaction, particularly when GE exists to
sell, not to acquire, jet engines. The underlying incentive for the
exchange is that the asset bought will be of greater financial value in
the future than the cash paid now.   A jet engine for a airline can earn
returns much higher than interests paid by banks for money deposits. By
the same incentive, the holder of the cash must seek another transaction
to acquire new assets of higher returns.  Hyperinflation occurs only
when most households choose to abstain from holding cash in anticipation
of rising prices, while producers refrain from cash transaction in
anticipation of falling value of money. When the rate of price
appreciation exceeds interest rate for money, hyperinflation will
result.  The macroeconomic implications of this is that a greater
reliance on seignorage (the capital gain generated by the creation of
reserve money) increases the rate of inflation, and can ultimately cause
a hyperinflation. It is difficult to restore a currency's place in
exchange after a hyperinflation without substantial economic pain.
Seignorage is the amount of real purchasing power that a government can
extract from the public by printing money. When a government prints
money, it is in essence borrowing interest-free since it receives goods
in exchange for the money, and must accept the money in return only at
some future time mostly through taxation. It gains further if issuing
new money reduces (through inflation) the value of old money by reducing
the liability that the old money represents. These gains to a
money-issuing government are called "seignorage" revenues.  The original
meaning of seignorage was the fee taken by a money issuer (a government)
for the cost of minting the money. Money itself, at that time, was
intrinsically valuable because it was made of metal.

Economic policy planners aim to arrive at a stabilization policy. John
Taylor wrote in  Stabilization Policy and Long-Term Economic Growth
(1996): Macroeconomic stabilization policy consists of all the actions
taken by governments to (1) keep inflation low and stable; and (2) keep
the short-run (business cycle)
fluctuations in output and employment small."   It includes monetary and
fiscal policies, international and
exchange rate policy, and international coordination.

Between 1935 and 1949, China experienced a hyperinflation in which
prices rose by more than a thousand fold. The direct cause of the
hyperinflation is easy to isolate: the Nationalist government
continually injected large amounts of paper currency into the Chinese
economy. The monetary expansion was so severe that during World War II,
Chinese printing presses were unable to keep up, and Chinese currency
printed in England had to be flown in over the Himalayas.  I will post
later more details on the history of Chinese hyperiflation.

A prerequisite for any sustained inflation is monopoly control of the
money supply. In the absence of a monopoly, individual market
participants simply will switch to a competing currency when one becomes
inflated. Thus, a key question in the study of any inflation is how the
state obtains monopoly control on money. As Chartalism requires state
control of a monopoly on money, Chartalism is often confused with
inevitability of hyperinflation.

Backed by historical evidence for the soundness of a free banking
system, one of the major arguments is that competition in the supply of
money forces banks to maintain either their brand names or
convertibility of their liabilities (banknotes or deposits) into specie
or real commodities, which in turn prevents banks from over-issuing
money. In contrast, a self-correcting mechanism does not exist under
monopolized supply of money by the government. Therefore, free banking
is more stable than central banking.

In the U.S., from 1839-1863, banks could issue their own money, called
bank notes. A bank note was a risky, perpetual debt claim on a bank
which paid no interest, and could be redeemed on demand at the original
bank, usually in gold or silver. There was a risk that the bank would
not be able or willing to redeem it.

Some economists, though not necessarily advocates of free banking, argue
that banking regulations (such as interest-rate ceilings, restrictions
on loans and investments, and required reserves) can be a source of
instability. The major ways in which regulations affect the stability of
financial institutions are:
First, regulations constrain banks' diversification by limiting banks'
portfolio choices or by restricting branching, thus reducing the
flexibility of banks to accommodate unanticipated shocks.
Second, as implicit taxes, regulations reduce banks' profitability.
Third, regulations often create a moral hazard problem by encouraging
risk taking.
Fourth, while it may be the intention of the regulatory authorities to
promote banking stability by interventions through monitoring,
supervising, and preventing fraud and incompetent management, it is
usually the case that supervision is inadequate.

Asset pricing models provide a way of mapping from abstract states of
the world into the prices of financial assets like stocks and bonds. The
prices are always conceived of as endogenous; that is, the states of the
world cause them, not the other way around, in an asset pricing model.
Hyperinflation is also endogenous.

Yet, such structural pitfalls are not exclusive to Chartalism.  For
Chartalism is not a liscense to run unlimited government deficits.  For
Chartalist monetary policy to work, the supplied of money cannot be
unrelated to the taxable base of the economy.  Since that taxable base
is more visible in the employment rate and the wage scale, Chartalism in
fact provides a structural protection for a healthy economy.

Henry C.K. Liu