The 4 Steps to Hyperinflationary Booms

By Dr. Jeffrey Lewis    Jan 20 2010 9:50AM

With the current US deficit soaring above $12 trillion, the conditions are ripe for inflation. However, is hyperinflation just around the corner?

Step 1: A Collapse

Before hyperinflation can begin, there is often a collapse, or series of collapses, that send currency prices higher. Fleeing from assets, whether metals, stocks, or even real estate, investors sell their holdings for currency or cash. When you sell an instrument, you are not necessarily selling an asset as much as you are buying another.

For instance, should you sell real estate, you are buying dollars, which you receive in trade for your property. This increases the demand for paper currency, and ultimately, its value. Cash equivalents, money markets and treasury bonds, for example, also rise in value, as they are seen as safe-haven investments that also provide a small, although tangible, return.

Step 2: Keynesian Solutions

After a collapse, Keynesian economics calls for an increase in government spending, as well as an expansion of the money supply to calm the markets. Although the validity of Keynesian economics is questioned by other schools of thought, it is the prevailing think-tank philosophy employed by most governments and central banks.

Government spending is usually increased by the creation of new entitlement programs (think Social Security) or stimulus spending (think New Deal and the American Reinvestment Act of 2009). These new programs generally increase debt loads and simultaneously increase the amount of money in circulation.

While these programs are in service, the central bank must also act to keep interest rates low. As expected, during such periods of economic calamity, investors want safety and are generally unwilling to invest.  The central bank usually acts to decrease interest rates, increase the money supply, and provide ample credit to governments to fund the ventures.  Keeping interest rates low also minimizes the long term cost of stimulus by making borrowing less expensive.

Step 3: Weeding Out Bad Investments

The markets are keen to find the most rational prices for any good or service, as well as the value of money. Although central banks have intervened at this point, there are still plenty of bad investments that need to go bankrupt for the system to correct itself. This can include unstable governments, debt laden corporations, or producers that have yet to establish themselves.

In this step, another exodus to cash usually occurs, as local destabilization flows through the economy. In the most modern occurrence, the automotive industry would have been the prime suspect for collapse; however, government aid avoided the closure. The mal-investment was not allowed to be removed from the system and re-established through bankruptcy.

Not all bad investments are protected by inflationary economics, however, as homebuilders and other “boom” industries were weakened substantially through the downturn and have consolidated.

Step 4: Rampant Inflation

Throughout Step 2 and Step 3, interest rates are kept low, stimulating the economy’s desire to borrow, which subsequently increases the money supply. In Step 4, the central bank must tread carefully. Raising rates too high can reduce the money supply too much, sending the economy into a death spiral. Knowing this, the central banks usually keep interest rates too low throughout the recession and allow for inflation, which is seemingly a better consequence than an economic fallout.

Although inflation is enemy number one for the working class, investors can pocket a plethora of profits. Stocks and other hard assets, such as gold and silver, often multiply in price, protecting the spending power of investors at the cost of those not yet invested in hard assets. It is most important that each investor have a backup plan of gold or silver, which can help protect savings from inflation, while holding their spending power until economic conditions improve.

Dr. Jeff Lewis

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Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-R eview.com