Understanding Budget Deficits, and how it causes Hyper Inflations

Govt is always a net consumer. The govt taxes the production of its citizens to obtain money for its expenditure. If the taxes collected and the expenditure balance out then the budget is balanced. But we have a problem, people do not want to pay more taxes, the people want some freebies ie subsidies and other free stuff, and the govt is inefficient and govt servants maybe siphoning out the money. This means that its difficult for the govt to balance its budget, and most likely it results in budget deficits.

The Central Banks (except the special case of ECB) are under the directive of the Government. They must provide money to the Government as much as they require. The govt will give some collateral to the bank, in the form of a Debt Note. The Central Bank will then try to sell if off, to whoever may buy it. Normally banks buy them, because they are safe investments. The govt will be able to pay off the loan, because they can issue another debt note to the Central Bank, and the Central Bank will provide the govt money to pay off the loan.

Money is created when the Central Bank gives it to the govt, and it is destroyed when the govt returns money to the Central Bank. Most of the time the Govt is just receiving money from the CB. The money provided by the CB is called base money. Money can also be created by a normal bank, when it loans more money to the people than it has. This money is called credit money. Base money most of the time grows. Base money is critical to understanding HyperInflations. Credit Money have little impact on it, as during HI, the normal banks do not make loans.

The govt pays money whenever it buys something or pays salaries to its employees. If this money is in excess of what it received from the citizens as taxes, there is more money in the market. The govt gets this money from the CB by issuing the debt note. This debt note is sold by the CB. The people deposit the money they received from the govt into banks. The banks use this money to buy the debt note. It is no risk investment for the banks. As long as this process works, there is no extra money in the market, and there is no added effect of inflation.

The debt selling is basically kicking the can down the road, as the debt must be payed back in the future when it matures. The govt may again create more debt to pay off the maturing debt. There by kicking the can further down the road. Another option would be to reduce the deficit and actually pay off the debt from the money from collected taxes.

It never makes sense for the govt to increase taxes and fire their employees and tighten their budgets. The people do not like it. So the only option for the govt is to kick the can down the road. The ability to receive free money, allows the govt to grow, to unsustainable levels. The people also love it as there is more spending for the masses. The actual producers have higher taxes, but not high enough that they care too much. Eventually the debt becomes so big that the govt cannot service the interest payed in the debt, within the tax collected. When this happens the govt must reduce the interest rates so low that it can service the interest.

When the interest rates reduce, the banks reduce the loan rates to match and start paying low interest on their deposits. Due to low interests people start taking more loans and stop depositing money in the banks. Now the banks do not have enough money in the banks to buy debt. They need to sell it, so the govt can no longer sell more debt to banks. The Central Bank at this point must buy back the debt, providing money to the banks. Once this starts to happen, the money stays in the economy. Due to the easy access to money the govt has increased its expenditure to enormous levels. The govt cannot easily reduce the deficit. There is also no point in tightening budgets at this point, as the production is not enough to pay off the debt. At this point Hyper Inflation becomes inevitable.

Peter Bernholz studied a number of hyperinflations and came to the conclusion that the point of no return is when Debt grows more than 80% of GNP, and deficit grows beyond 40% of Budget. If the deficit is reduced again, then the problem can be contained, but unless it was due to a war, it is not possible to reduce the deficit.

The hyperinflation does not start as soon as govt starts to buy debt from the banks or it goes beyond the limits given by Bernholz. Even though the money is entering the market, it must be chasing ever lesser number of articles, for hyperinflation to start. If the money stays in banks, then there is no problem. The banks are also not paying much interest and they are fearful of lending it to people, as they are risk averse at this point. The economy is not doing well during these times. That is part of the reason for the increasing deficits. So the money can stay in the banks for a long time. Actually due to this risk averseness, the economy may face a deflation, causing the govt to pump out more money, in an effort to prevent deflation.

If the banks are allowed to trade in the markets, they start to buy stocks and other assets. This causes the market value of those assets to rise. Due to the rise in these assets companies start to get more money. They are able to hire more people and give larger salaries. The market enters an upbeat mode. People get more money, and they start to buy stuff. This allows spending to increase. The excess money starts chasing real day to day objects. The inflation may pickup at this time, depending on whether there is enough objects in the market. As long as everybody can get what they need there is no problem and the prices will not rise. The country starts to buy stuff in the international market with the created money. As long as the international market perceives the currency to be trustworthy, the country can import stuff, and the inflation is not a problem.

Basically at this point, inflation will happen in whatever stuff is not easy to get at. If that stuff is not important, people will move to other stuff. As availability gets lower for more and more stuff, the public starts seeing high inflation. Eventually the inflation rate gets high enough that people do not want to hold the currency. At this point they will buy anything that they can get their hands on. This is the point of runaway inflation, or hyperinflation. The govt must support itself, so it must print ever higher amounts of currency to pay salaries to its employees. Credit money disappears, as the banks no longer give out loans, and they basically become a part of the govt. The govt starts to take over many failing businesses that it needs for its employees to use.

Eventually the govt employees do not earn enough money from the govt, and they start doing other stuff. The govt starts downsizing. This is the end phase of the hyperinflation. When enough people have left govt jobs, the deficit can be controlled. The govt can start a new currency, and restart the economy.

Lets see how this relates to the US.

The 70s saw US Government get into perpetual deficits. They have been in deficit for 40 years. Initially Europe and Japan where absorbing the deficits in the form of Treasuries and bonds. After 2001 when Euro was formed, Europe backed out from buying Treasuries. Then China started buying the treasuries. The debt became too big to be processed in 2005, and that year saw the interest rates dropped down to near zero. The banks started to fail in 2008, which required the govt to start buying debt.

China stopped buying debt/treasuries in Sept 2011. The govt started Operation Twist to buy long term bonds and convert them to short term debt. As we can see in the following graph it was increasing base money.

Now the only way some of this deficit is being absorbed is through Currency War. Some countries notably Japan, Brazil, Australia are devaluing their currencies by buying USD, so that the USD does not depreciate in their currency. Then they have to buy treasuries from the USG against those USDs. In QE3/4 FED has announced that it will buy 85 Billion USD worth of Mortgage bonds every month. In the graph above we can see that it has already printed 300B in the last 3 months.

The HI in US economy has been inevitable for at least the last 5 years. But now the vicious cycle has started as the govt has started buying 85 billion USD worth of debt every month. The US population has been a non-saver for a very long time now. So the deficit has been bought by foreigners rather than US people, for a very long time now. Notice that during this month the stock market has finally started to go up. This is due to the massive printing by govt. The next stages are clear. US should start to get some sort of inflation in daily use items. But this may take some time as the USD is the reserve currency and the US is able to buy things from the Rest of the World using those USDs. So it will be able to buy stuff, to prevent the prices to rise in the market. So before inflation sets in, the Rest of the World has to stop selling stuff to US. This can only happen if they remove their dependency on USD, which is actually dependent on the Middle East which sells them oil for USD.

The Middle East actually wants gold, so they will only sell their oil for USD till they can buy gold in USDs. This is the basis of petrodollar. So the trigger can be one of two things. 1) Panic in the trading world, due to collapse in UK or Japan. 2) Collapse in the price of gold, and gold goes into hiding.

1) Remember UK and Japan are considered safe havens, but their economies are in nearly as much bad condition as US. They will also undergo hyperinflation. They are not protected like US, as their currencies are not the reserve currencies. The condition of UK is a bit worse, and they have also started US style printing. Japan is a bit behind, and they are undergoing deflation, because they haven't been printing enough. That is about to be rectified. If one of these country's economy collapses, it could trigger the rest of trio to collapse as well.

2) Paper gold market is dropping a lot now. This is seen in the gold prices. At lower gold prices Asians buy a lot more physical gold. This means that physical gold supply becomes tight. If the price of gold goes even lower, the mines can shut down, resulting in even lesser availability. Also the western people that are dishoarding lose interest in selling their gold, because they think that they are making a loss by selling at such cheap rates. If the gold supply disappears, middle east oil nations will not get gold for dollars, and they will be less inclined to support US dollars.

We are basically in the last stage of the collapse. And gold will not be available for much longer.

There is a way in which normal people can break this cycle. The way is to not store money in banks. The money stored in banks WILL be used to buy govt instruments, which allow govt to do deficit spending. The only way out, is putting your money in stocks, land and gold. Never in bank instruments, Fixed Deposits, Mutual Funds etc. Also invest only in companies that create something, not in stock of banks.