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Is the 'Worst' Over?; Reflation and the Structure of Hyperinflation

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"The mark plunged down, never to stop until it had reached the fantastic figures of madness – the millions, the billions and trillions."

Stefan Zweig


Amid the short financial market crisis, I wrote the blog post - "A Minsky Moment or A Fiscal Bonanza?" and I talked about four essential things that I would be looking for in the policymakers' decisions.

  • Containing spread of SARS-CoV-2

  • Counter the demand slowdown by a fiscal measure

  • Help the SMEs and levered firms meeting their contractual payments, and

  • Restore sentiment of investors by improving financial conditions.

Only some countries focused on the first, while most of the countries focused on the economic crisis. The Fed saved the day for most investors, businesses, employees, states, and citizens. Is the worst over?

In this blog post, I will provide my analysis on the current economic situation, and offer my take on a successful reflationary scenario. The difference between successful and unsuccessful reflationary scenario is solely depended on good policies. If there will be policy delays, the oscillation (volatility) will rise; if there will be policy mistakes, economic and wealth inequality could increase, and geopolitical and civil crises could ensue; and finally, if there is the exhaustion of policy tools, then inflation could accelerate.

I am using example of the US economy.

A. The Current Economic Environment and the Reflationary Scenario

Due to the pandemic, demand and consumption fell. A lot of firms started to lay-off workers, increased the unemployment rate and impacted total disposable income in the economy. The government stepped up and provided jobless insurance income and provided a one-time discretionary check to support the households.

As you could see in the next chart, consumption fell by ~ 15% in the second quarter of 2020, while total personal disposable income grew by ~ 12% (including government assistance). It decreased the probability of the worst-case scenario and provided relief to the workers and economy in the form of offsetting extreme demand slowdown.

Source: Datastream and

The situation created new problems in the system, mainly the rise in the public and corporate debt, another problem is the reliance on government assistance to stimulate the economy until the system finds a new equilibrium to support itself.

Source: Datastream and

Subsequently, the central inquiry would be on how much debt is too much? I will first discuss the corporate balance sheets. The corporate balance sheet is resilient unless and until the income flows can pay contractual obligations and meet the equity holder's expectations.

I am dealing with aggregate numbers in total awareness that the economy is made up of parts. Some firms will benefit from the aggregate development, while others will feel the storm.

Due to fall in consumption, the total business sales reduced. As you could see corporate sales to disposable income decreased. Profit margins has declined initially, as the sales decline is faster than the expense decline.

Source: Datastream and

There are two major scenarios from here:

1. The rise in income (through more and more government assistance) will increase the consumption, expanding corporate sales, and increasing corporate portability and economic output. (my probability 60%). The successful reflation is dependent on the probability of this scenario. Although it will require a massive amount of government assistance. (Reflationary Scenario)

2. The rise in income will not translate into consumption, decreasing corporate sales. (my probability 40%). There will be two scenarios out of this particular scenario -

a. Firms will maintain their profit margins, reducing expenses with the same or higher amount than sales decline. It will lower the total income (trough lower employment) and create a downward spiral, wealth in-equality, civil and geopolitical crises. (price deflationary scenario)

b. The firms' profit margins will collapse, impacting their ability to pay contractual obligations. It will create many bankruptcies and cause a significant downturn in the economy. (debt deflationary scenario).

B. Blind-Spots, Vulnerabilities and What is at Stake?

Capital markets have a non-linear relationship with the economy. Sometimes they will be perfectly correlated, while other times, there will be no relationship or a negative relationship.

Capital markets are a function of - 1. Economy, 2. Political System or Structure, and 3. Central Bank's Policies.

At a corporate structure level -

I am structuring capital markets into two building blocks only - equity and debt instruments. If we look at the economic expectations (absent government support), the hope of future sales and profits are low, but equity and debt instruments have seen a bullish rally. The central bank's added liquidity has flown into capital markets.

Due to Central banks' independence, they can only influence capital markets such as liquidity and risk premiums. They cannot control the economic output directly. Governments can impact economic production and profitability. A scenario for a successful reflation is dependent on fiscal authorities.

If central banks keep on saving capital markets by pumping in excess liquidity, and fiscal authorities do not act, there will be an extreme imbalance in the equation --

Total Expected Excess Profits (Growth Assets)+ Total Market Value of Assets = Total Debt + Total Market Value of Equity

- that is, the debt and equity instruments will over-value, while future expectations of economic output will stay abysmal. It will create massive inequality, imbalances and a rise in 'carry' trades. Any subsequent disappointment or panic in assumption will create a financial asset collapse. The nightmare scenario is not part of some dystopian story but our current reality.

Source: Datastream and

So, the only reasonable outcome out of all the scenarios is the reflationary scenario led by the fiscal authorities. It will avoid a deflationary scenario that will lead to inequality and avoid debt deflation and all the pain on financial prices collapse.


One of the biggest blind-spot is the current structure of the economy. The structure formed by income distribution, supply chains, competitive advantages, public-private structure, debt distribution, equity markets, etc.

If policymakers make an aggregate decision to improve demand by providing pay-checks, the money will flow according to the current economic structure. The players or entities that benefit in this system will re-enforce their advantage. In such a scenario, there will be an uptick in the economy momentarily, but the problems such as income and wealth inequality will rise. It will also form big monopolies (or expand existing ones) in the economy, influencing supply-demand and, subsequently, prices. A successful reflation will not be reached, and the problems will persist.


If there will be errors in the policy-making or if the system loses its resilience, it will collapse.

Here are the following vulnerabilities:

1. Equity holders and debt holders will panic and lose hope of recovering their investments. Bankruptcies will increase massively.

Source: Datastream and

2. Central banks will have to increase liquidity in all the panic scenarios to reduce the probability of financial asset collapse.

Source: Datastream and

3. Governments will need to borrow a lot of money for a successful reflation, but their balance sheets are weak. If capital markets stop functioning well due to financial asset collapse, exhaustion of the central bank's policies or foreign government debt holders losing faith in the US dollar, the inflation will accelerate rapidly.

Source: Datastream and

4. Central banks will have to devalue its currency by printing as they cannot reduce interest rates to stimulate capital markets. It will be used to buy US Treasuries that will be needed for successful reflation and avoiding financial asset collapse. Obviously, debasement of currency will lead to price inflation (after or during the reflationary years.)

Source: Datastream and

C. The Structure of Hyperinflation

1. Inflationary Bias of the Political Systems

  • Hyperinflation always caused by public budget deficits - financed by money creation.

  • Democracy. Short term thinking. Financing public deficits by creating money.

  • All hyperinflation have occurred in discretionary money regimes (non-metallic).

  • As Central Banks lose independence, the chances of hyperinflation increases.

  • Hyperinflation only occurred after revolutions and wars.

  • Inflation - positive side effect - reducing public debt. Initially welcomed.

  • Followed by negative economic consequences.

  • Higher inflation vs trading partners would lead to devaluation of the currency and stabilization of this money.

  • Taming the inflation to save the currency and empire.

2. Gresham's Law - "Bad Money drives out Good"

  • Historical concept from coinage times.

  • "Good coins driven out of circulation by the new bad ones."

  • People save the 'good money' and use 'bad money' for exchange.

  • In the modern context, the money for storage of wealth (good money) is replaced by bad money in the exchange market.

  • In other words, money used for storage is not the same as money used for exchange.

  • Hypothetical example, Gold or other currency replacing the Dollar as storage of wealth, while Dollar retaining its hegemony in the exchange market.

3. From Gresham's Law to Theirs' Law

  • Holders of inflating currency will see their wealth erode - inflation tax.

  • Undervaluation of the paper money develops vs gold, silver or more stable paper money.

  • Not true if trade with foreign countries is interrupted.

  • Increase of money supply stimulates economy; prices increases lag.

  • If money supply's growth is substantially reduced, the depressive consequences are felt before price increase recedes.

  • Moderate inflation --> high inflation leads economic adverse conditions.

  • Wage increase lag behind price level.

  • A real budget deficit cannot be maintained permanently.

  • The government must reduce it or the new good money will completely drive out bad money out of storage (of wealth) and circulation. It will erode the base of inflation tax.

  • Currency substitution - if high inflation is persistent.

  • Theirs' Law - Bad money is replaced by good money out of circulation, too.

  • Complete replacement of old bad money by new good money.

4. Main Characteristics of Hyperinflation

  • Currency substitution implies undervaluation of the inflating currency.

  • Capital markets are usually reduced in scope.

  • High inflation do not promote growth of GDP.

  • Lowers unemployment.

  • In the beginning, it promotes both employment and GDP.

  • At the height of hyperinflation, growth is negative and unemployment increases.

  • Taming of inflation. (Not provided in the blog post).

Thank you for reading. :)

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