I have been reading the inflation/deflation debate for some time now on various parts of the web. The inflationists insist that we will collapse like Wiemar. The deflationists insist that we will collapse like Japan. The memory of the 1970s inflation is strong in many an old gold curmudgeon, so the inflationists seem to be more prevalent. I will in this essay attempt to argue that hyperinflation will not happen if global commodity markets remain priced in dollars. The reason for this is that if inflation increases, the rest of the world will bid commodities up drastically, especially oil, and severely throttle U.S economic growth, leading to a more restrictive monetary policy.
Hyperinflation always happens due to a foreign exchange crisis. The population, sensing a high level of inflation, rushes to change their earnings in for real goods or foreign currency. In the case of Wiemar, or Argentina, the rest of the world is largely unaffected. They see their currencies drastically appreciate against the hyper-inflating currency, but that has little affect on their internal economies. Consumption of oil and commodities remains relatively flat in these countries and existing relationships are largely preserved.
If Ben Bernanke were to fire up the proverbial helicopters and start dropping money over the country, the first thing that would happen would be the money would not go directly into foreign currency. Instead, it would go down to walmart and buy itself some imported goods. Then the money would go via walmart, to China and from China, back into treasury bills. Don't worry, there are plenty of treasury bills to go around. In China it would lead to more domestic currency creation and therefore increased production, and workers wages and from there, into domestic consumption.
China is currently the largest market in the world for automobiles. People who buy automobiles need to fill up gas tanks, especially Chinese workers with fresh new currency in their pockets. The increased consumption of oil and other commodities in China would necessarily lead to the price of these commodities increasing on the global market. China intervenes regularly with their dollar reserves to keep domestic prices of commodities stable.
As this dynamic continues, we will start to see the Baltic Dry Index go up as many ships merrily steam across the pacific delivering goods to happy American consumers. We will also concurrently see oil and other commodity prices shoot through the roof. As oil prices shoot up, the economy in the U.S will start to experience a very heavy drag, as it did in 2008, when oil hit $150 a barrel. These added costs will quickly send the inflation indicators out of control, even though FX rates will only be moderately affected due to the Chinese currency peg. At this point, Ben will probably hit the pause button on the printing machine and we'll have a late 2008 style deflationary crash.
Recently, Bullard at the Fed was talking about doing an instant-refi of all mortgage holders at lower rates. This will provide another temporary boost that might last a year or two. It would annoy the lenders, who would have to accept a lower coupon and might be outside the fed's mandate. It's not the kind of hyperinflation generating event though that would precipitate a scenario like the one above, mainly because I don't think it can start another asset bubble as all the loans in question are still underwater.