Is UK set to go the way of the Weimar Republic?

By Michael Baxter 22 Mar 2010 [2 Comments | 872 views]

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Predictions that the UK could be set to go the way of the Weimar Republic of Germany in the early 1920s are reaching a new fever pitch.

You will no doubt recall from your history books that in Germany between 1914 and 1923, inflation went off the map. Give the German wholesale prices index a score of 1,for 1914, then by the end of the First World War it had risen to 2.6. But that was just the beginning.

By January 1920 the index stood at 12.6. A year later it was at 36.7. By July 1922 the index had broken though the hundred barrier. And that was when things got nasty. By January 1923 the index stood at 2,785. By July it was at 194,000. By November of that year the index was at 726,000,000,000. To fight inflation the government brought in a new currency, backed by hard assets.

See The German Inflation Nightmare

The question is, will the UK go the same way? There is no shortage of those who say she will.

Writing for Money Week, Tim Price said last week: “Imagine if UK gilt yields start to rise rapidly, as investors question the political will to tackle the deficit. Sterling, having weakened markedly over the past year, starts to freefall. But the market understands that the economy will be too fragile for the Bank of England to raise interest rates to defend the currency (a situation similar to the UK’s ultimate ejection from the European Monetary Union in 1992). A sterling crisis becomes a rout. Inflation, perhaps superinflation, enters via the imports market.

“Those who have studied the Weimar experience suggest that the point of no return in the inflationary process did not come about through currency depreciation alone, nor from the growing velocity of money in circulation, nor from the balance of payments deficit. In fact, it came from a devaluation of political principles. In the words of Adam Fergusson, author of When Money Dies: The Nightmare of the Weimar Collapse: ‘What really broke Germany was the constant taking of the soft political option in respect of money’.”

Nassim Nicholas Taleb is no mean economic commentator. There are those who say his book “The Black Swan,” was the best popular economics book written during the last decade. Although, that is a little unfair on his previous book, “Fooled by Randomness,” which was actually a better book, in the opinion of the author. (And of course the author’s own book, “Bubbles and Wisdom,” is even better!)

But so impressive were Taleb’s books that investors and the media have started listening to his words with rapt attention. Earlier this month, when making a speech in new Delhi, Mr Taleb said: “We are facing an environment with a huge amount of debt. The next mistake is going to be overprint, which is going to be the way out for them, which is why I fear hyperinflation.”

“Why is the state converting private debt into public debt?” asked Taleb. He answers his own question, saying: “because public debt is permanent.”

Mohamed A. El-Erian, Co-chief Investment Officer at Pacific Investment Management Co., has also raised similar concerns

Meanwhile, John Lipsky, First Deputy Managing Director of the International Monetary Fund, is worried about government debt across the developed world. Last week he gave a grave warning on mounting government debt. In classic IMF understatement he called it “worrisome”, and said: “This surge in government debt is occurring at a time when pressure from rising health and pension spending is building up.”

Another good book rattling about in the shops at the moment is, “This Time it is Different,” by Reinhart and Rogoff. The two authors, who are both economics professors, drew upon an impressive range of data going back 700 years, showing how government borrowing often precedes economic catastrophe.

But there is a snag.

Lets look at Taleb’s claim first. Here is a suggestion for Mr Taleb: before you say anything else, read your own books. The whole point about his first book, “Fooled by Randomness,” is that we fail to see how unpredictable the future is. We look back at history and apply our wise-in-hindsight analysis, but we don’t really know if such and such an event causes something else. He gave the example of a melted ice cube. Someone who appeared on the scene after the event would have no way of knowing why there was a pool of water. And even if they had somehow guessed there had been an ice cube which had then melted, they would have no way of knowing the shape or position of the ice cube. Taleb’s argument was that the world is random, and we are far too quick to make forecasts based on history that has no relevance.

Taleb called it the ‘narrative fallacy’, which he described as “our need to fit a story of pattern to a series of connected or disconnected facts”.

Taleb made his name by saying the future is nigh on impossible to predict, and now he is being quoted as if he is some kind of soothsayer.

What Taleb did say, however, is that we tend to understate the chances of something quite unexpected happening, what he called the ‘black swan event’, after the discovery of black swans in the New World meant we had to change the definition of what a swan looked like.

So an investment model true to the black swan principle would say that events considered by the markets to be rare, such as a banking crisis or hyperinflation, occur more often than is commonly realised. And investors who bet on rare events will lose money most years, but when the bet comes off, will make far more money than they had previously lost. At least so goes the theory.

So by warning of hyperinflation, Taleb is in fact arguing against himself.

Taleb’s argument was based on the idea that we are not good at allowing for rare events. But look at how the price of gold has soared, and you will see that the markets are factoring in the danger of hyperinflation.

As for the “this time it is different” argument, this, too, is flawed.

Of course, the statement is meant to be ironic, ie, in practice each time it is the same.

But that’s not true; every crisis is different. Sometimes, such as in the dotcom crash, we saw markets getting ahead of themselves. They correctly reasoned the Internet would change the economy, but they were a couple of decades too soon. Other times, bubbles grow on the back of hype, and nothing else.

Reinhart and Rogoff are guilty of what psychologists call the confirmation bias. This is a bias we are all guilty of, on occasions.

We make our mind up that something is true, and then we look for evidence to support that view and reject all evidence to the contrary. So we may decide such and such a person is lazy, and seize upon the occasion they are late for work to confirm our view, and ignore the occasions they work through the night.

It is quite possible that the confirmation bias is the stuff wars are made of. It is probably the one common denominator to bubbles.

What Reinhart and Rogoff didn’t do, was to look at the occasions when government debt did not lead to a major crisis. For example, the UK’s total government debt after the Second World War was 250 per cent of GDP. And yet the 25 years that followed was the best period for economic growth ever experienced by the UK.

Each time, it is nearly always different.

So, just because printing money led to hyperinflation in the past, it does not necessarily mean this will happen in the future. Just because massive debts have on occasion led to sovereign debt crises in the past, it doesn’t follow they always will in the future.

Sometimes we borrow because we are confident about the future.

Sometimes our confidence is misplaced, but not always.

Right now, wage inflation in the UK is almost non-existent. In the 12 months to January, average earnings including bonuses rose by just 0.7 per cent. Hardly the kind of wage increases that hyperinflation is made from.

If inflation is caused by a rising money supply, explain how it is that UK M4 lending, excluding the effects of securitisation, contracted by 5.6 per cent in February. Explain how it is that in the US, M3 money supply as estimated by Capital Economics has contracted, quarter on quarter, for seven months in a row. See US money supply contracts like a boa constrictor and If money grew on trees, we would be in the midst of deforestation

Price goes up when demand is greater than supply. Inflation occurs when there are pressures meaning demand is consistently greater than supply. Right now, across the global economy, potential capacity is vastly greater than demand.

The real problem today is not quantitative easing. Rather, it may be more accurate to say quantitative easing is the right policy, but it is being implemented by the wrong countries.

Germany in particular is terrified of any form of money creation, because of the experience of the Weimar Republic. The mistake the Germans are making is to fail to realise that, this time, it really is different.

PS: In the picture, a women is shown feeding a stove with currency notes, because this works out more cost effective than using the money to buy wood.

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