Chinese Hyperinfaltion:1939-1950

Origins of the Chinese hyperinflation

To preserve confidence in the new currency, the Decree contained provisions to establish a “Currency Stabilization Fund.” The Fund was to buy and sell foreign exchange in order to keep the exchange rate of the Chinese currency approximately constant relative to certain foreign currencies. The Decree also contained provisions to alter the function of the Central Bank. Instead of merely being an arm of the Nationalist Treasury, the Central Bank was to become a “banker’s bank” distinct from the Nationalist Treasury.[17] Also, the Decree maintained that “plans of financial readjustment have been made whereby the National Budget will be balanced.”[18] And, according to Finance Minister Kung, “The government is determined to avoid inflation . . . .”[19]

The wording of the Decree was the government’s attempt to quell fears of inflation. Chinese newspapers ran editorials assuring the public that the Nationalists had nothing but the best intentions for the Chinese economy, and the move to a paper currency was heralded by economists around the world as a step toward a modern banking system. But, despite the provisions of the Decree, the Central Bank was never removed from the Treasury’s control. Even more fraudulent was the assurance that the budget would be balanced. Indeed, the government deficit increased in the years following the currency reform.

In retrospect, Kung’s statement seems like a cruel joke on the Chinese people. The currency reform destroyed the private banking system which had served the Chinese economy well, and placed control of the currency in the hands of a corrupt and inept government. Inflation began almost immediately. Eventually the inflation became so severe that it helped bring about the collapse of the Nationalist regime. Thus, monopoly power over the currency proved fatal to the Chinese economy, since the inflation that Kung was “determined to avoid” occurred with a severity and length unparalleled in history.

Bernankeism in Rome

Inflation and the Fall of the Roman Empire

Now, what were the consequences of inflation? One of the odd things about inflation is, in the Roman Empire, that while the state survived — the Roman state was not destroyed by inflation — what was destroyed by inflation was the freedom of the Roman people. Particularly, the first victim was their economic freedom.

Rome had basically a laissez-faire concept of state/economy relations. Except in emergencies, which were usually related to war, the Roman government generally followed a policy of free trade and minimal restriction on the economic activities of its population. But now under the pressure of this need to pay the troops and under the pressure of inflation, the liberty of the people began to be seriously eroded — and very rapidly.

Bernanke: The Fed’s Exit Strategy

The Fed’s Exit Strategy by Ben S. Bernanke

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.


In other words, the only way fed can control inflation is by raising interest rates.
But it will not raise rates because that will further weaken the weak banks and the weak economy. It will let inflation run most of its course.

Hazlitt on inflation

What You Should Know About Inflation By Henry Hazlitt

Inflation, to sum up, is the increase in the volume of money and bank credit in relation to the volume of goods. It is harmful because it depreciates the value of the monetary unit, raises everybody's cost of living, imposes what is in effect a tax on the poorest (without exemptions) at as high a rate as the tax on the richest, wipes out the value of past savings, discourages future savings, redistributes wealth and income wantonly, encourages and rewards speculation and gambling at the expense of thrift and work, undermines confidence in the justice of a free enterprise system, and corrupts public and private morals.

But it is never "inevitable." We can always stop it overnight, if we have the sincere will to do so.

Inflation in ancient Rome

Quantitative easing in ancient Rome
It would seem clear that the major single cause of the inflation was the drastic increase in the money supply owing to the devaluation or debasement of the coinage. In the late republic and early empire, the standard Roman coin was the silver denarius; the value of that coin had gradually been reduced until, in the years before Diocletian, emperors were issuing tin-plated copper coins that were still called by the name "denarius." Gresham's law, of course, became operative; silver and gold coins were naturally hoarded and were no longer found in circulation.

During the fifty-year interval ending with the rule of Claudius Victorinus in A.D. 268, the silver content of the Roman coin fell to one five-thousandth of its original level. With the monetary system in total disarray, the trade that had been hallmark of the empire was reduced to barter, and economic activity was stymied.

Fiat Money Inflation in Revolutionary France, by Andrew Dickson

Fiat Money Inflation in France, by Andrew Dickson


It progressed according to a law in social physics which we may call the "law of accelerating issue and depreciation." It was comparatively easy to refrain from the first issue; it was exceedingly difficult to refrain from the second; to refrain from the third and those following was practically impossible.

It brought, as we have seen, commerce and manufactures, the mercantile interest, the agricultural interest, to ruin. It brought on these the same destruction which would come to a Hollander opening the dykes of the sea to irrigate his garden in a dry summer.

It ended in the complete financial, moral and political prostration of France-a prostration from which only a Napoleon could raise it.

So, even France in eighteenth century had its version of Paul Krugman, Ben Bernanke and quantitative easing.
It is needless too say that fiat currency inflation did not work. But it so interesting how people get seduced by this idea.

Gold and oil higher

Gold Prices Rise On Inflation Worries, Higher Oil

"The price of gold climbed higher on Thursday as encouraging economic data raise the prospects of inflation. Higher oil prices and the dollar's decline against the euro also boosted the precious metal's hedge value."

My investment plan for this business cycle

Every inflation cycle is different.

Following is my plan for this business cycle.

In the initial stage of inflation -
1. Refinance to a 30 year fixed rate loan at a rate below 5%
2. Buy some of following assets - precious metals, emerging market equities and currencies, Asia, commodities, natural resource companies, some too big to fail banks, healthy American industrial companies, and some junk bonds and prime rate funds. Keep some cash. Subscribe to Barrons.

Intermediate stage of inflation -
After the fed raises interest rates for the first time, become a momentum trader. Subscribe to a momentum trading newspaper like Investor's Business Daily and cancel Barrons. Trade with tight stop losses.

Terminal stage of inflation-
After the fed raises rates by at least 2%, start preparing for deflation and reversal of dollar carry trade. Take profits of assets acquired in the initial stage of inflation. Raise cash. If treasuries are above 5%, start nibbling them. Even if treasuries remain in a secular bear market longer than the business cycle, they will provide a risk free arbitrage due to existing mortgage. Subscribe to Barrons again.

Remember also that markets work through deception.

What is your plan? Please share in the comments section.

Lets do an experiment

Lets stand in one corner of the room and continuously pour water on the floor. Now, ask your friend to stand in the opposite corner with a measuring stick. Let him measure the water level. As water has not reached the other corner yet, let us pretend that the water level will never rise. Who are we fooling? And yet, the federal reserve wants us to believe that it can continue to pour money into the system and inflation will not rise.

Three stages of inflation

Every inflation eventually leads to a deflation. There are three stages of inflation.

The initial stage of inflation overlaps with the previous deflation.
People are unsure about their investments and some think that deflation will continue. Value investors perform best in the initial stage of inflation. People who take cheap loans also win. Credit starts to flow to sectors where fundamentals are the best. Every inflationary cycle is different.

In the intermediate stage of inflation, credit continues to flow to sectors where credit is already flowing. The reason is that it is easiest to pay off the debt with a profit if more debt is taken after you have taken debt and more people buy the same assets that you bought. Momentum traders perform best in the intermediate stage of inflation. Technical analysts are mostly momentum traders. When people talk about inflation proofing their portfolio, they usually refer to only the intermediate stage where they see constantly rising prices. That is a mistake because inflation has a full cycle with profit opportunities in each stage.

In the terminal stage of inflation, every talks about investing. People who missed the boom of last few years want to jump in. There are new acronyms. Very soon inflation will be over and deflation will follow. There will be tightness of money.
Cash will soon be king. Risk averse people who hold cash and government bonds win. When deflation takes hold, some bold and prudent short sellers have a party time.

Unfortunately, it is hard to know which stage of the inflation cycle we are in exactly. But we only need to be approximate and more right than wrong to make money in the longer run.

Dollar carry trade ?

It appears that another round of dollar carry trade is starting. Last round had started in 2002 and ended in 2008.

Game of money

Wealth is not a zero-sum game but money is a zero-sum game without a perfect strategy. In fact, we can argue that it is a negative sum game because wall street and the government take their cut in the zero sum game. In a game like tic-tac-toe, a perfect strategy exists and if you follow that strategy, you cannot loose. Games like poker and chess do not have a known perfect strategy. But, that does not mean that good strategies do not exist. Strategy must be adjusted according to the moves of other players. The most important players in the money game are the central bank and the government. The strategy must be adjusted according to their moves. When you go to a casino, you have an option of not playing and keeping the money in your pocket. But what if the casino takes away a portion of your money every hour that you do not play? Then, you will be forced to play in the casino just to break even. Welcome to the casino where the government takes away your money through inflation even if you do not play.

Great quotes about inflation

"Inflation is always and everywhere a monetary phenomenon." — Milton Friedman

"Everyone loves an early inflation. The effects at the beginning of an inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the later effects, but the later effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation. " - Dying of Money: Lessons of the Great German and American Inflations by Jens O. Parsson


"Inflation profiteering had consisted of borrowing paper marks, converting them into goods and factories, and then repaying the lenders with depreciated paper. It was a process of which both Kutisker and the Barmats were pastmasters. Deflation profiteering, whose possibilities these Lithuanians (unlike Stinnes) rapidly saw, consisted of selling everything available for the new stable marks and — in this period of the tightest imaginable credit — lending the proceeds at extravagant rates of interest. " -When Money Dies: The Nightmare of the Weimar Collapse
by Adam Fergusson


"I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments."- Friedrich August von Hayek

"Inflationism, however, is not an isolated phenomenon. It is only one piece in the total framework of politico-economic and socio-philosophical ideas of our time. Just as the sound money policy of gold standard advocates went hand in hand with liberalism, free trade, capitalism and peace, so is inflationism part and parcel of imperialism, militarism, protectionism, statism and socialism." - Ludwig Von Mises

"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves." - Alan Greenspan

"If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered." - Thomas Jefferson

What causes monetary inflation?

In the current monetary system, the federal reserve and commercial banks cause monetary inflation. The federal reserve increases the monetary base by purchasing assets through its open market actions. The commercial banks then create credit every time money is lent. This occurs due to the system of fractional reserve banking which I shall explain later. But total credit in the system has to be less than the reserve ratio (10) * monetary base.

Increase in monetary base is usually the first step in causing monetary inflation. But that money needs to be lent out to cause credit expansion. Credit expansion is what causes amplification of the monetary base. The federal reserve can further facilitate credit expansion by lowering interest rates that encourages borrowing. But it cannot force it. Credit expansion occurs through debt contracts between willing borrowers and commercial banks.

Also, there is not much difference between qualitative easing and quantitative easing. When fed lowers target interest rates, it may need to buy short term treasuries (qualitative easing) to maintain its target rate. This increases the monetary base. However, fed may also buy long term bonds or any other asset (quantitative easing) which also increases the monetary base. Thus, the process of qualitative easing and quantitative easing is essentially same.