Hyperinflation, Money Demand, and the Crack-up Boom

In the early 1920s, Ludwig von Mises became a witness to hyperinflation in Austria and Germany — monetary developments that caused irreparable and (in the German case) cataclysmic damage to civilization.

Mises’s policy advice was instrumental in helping to stop hyperinflation in Austria in 1922. In his Memoirs, however, he expressed the view that his instruction — halting the printing press — was heeded too late:

Austria’s currency did not collapse — as did Germany’s in 1923. The crack up boom did not occur. Nevertheless, the country had to bear the destructive consequences of continuing inflation for many years. Its banking, credit, and insurance systems had suffered wounds that could no longer heal, and no halt could be put to the consumption of capital.1

As Mises noted, hyperinflation in Germany was not stopped before the complete destruction of the reichsmark. To illustrate the monetary catastrophe, one may take a look at the exchange rate of the reichsmark against the US dollar. Before the start of World War I in 1914, around 4.2 marks would buy 1 US dollar. As soon as war action began, the convertibility of the mark was suspended and paper marks (papiermark) were issued, largely for financing war-related outlays. In 1918, after the end of World War I, 8.4marks bought 1 US dollar.2 In December 1919, the mark had depreciated to 46.8 per US dollar, and in December 1920 to 73.4 per dollar.

In July 1922, the US dollar cost 670 marks. When French and Belgian troops occupied the Rhineland at the beginning of 1923, however, the exchange rate of the mark plummeted to 49,000 marks per US dollar. On November 15, 1923, when hyperinflation reached its peak, the currency reform effectively made 1 trillion (1,000,000,000,000) papiermarkequal to 1 rentenmark, and as 4.2 trillion papiermark exchanged for 1 US dollar at that time, 4.2 rentenmark would equal 1 US dollar.3

Increases in the Money Supply

The 20th century saw many hyperinflations, including China in 1949–50, Brazil in 1989–90, Argentina in the late 1980s and early 1990s, Russia in 1992, Yugoslavia in 1994, and, most recently, Zimbabwe in 2006–09. All of these hyperinflations were the direct result of a system of unfettered fiat money under government control — a system that produces money in a non-market-conforming way: the money supply is increased out of thin air by banks simply extending loans (circulation credit) and/or monetizing assets.

Hyperinflation is perhaps the darkest side of a government fiat money regime. Among mainstream economists, hyperinflation typically denotes a period of exceptionally strong increases in overall prices of goods and services, thus denoting a period of exceptionally strong erosions in the exchange value of money. Some people consider a rise in overall prices of 10 percent per month (which implies an annual rate of price increases of around 214 percent) as hyperinflation; others indentify hyperinflation as a monthly price rise of at least 20 percent (which implies an annual increase in prices of nearly 792 percent).

However, any such numerical definition can be criticized, as it refers to the symptom rather than the root cause of the accelerating loss of the purchasing power of money. Economically speaking, hyperinflation is the inevitable consequence of an ever-greater rise in the amount of money. And this is exactly what the monetary theory of the Austrian School of economics teaches: In fact, Austrian theory shows that inflation is the logical consequence of a rise in the money supply, and that hyperinflation is the logical outcome of ever-higher growth rates in the money supply.

According to the Austrian school, money is, like any other good, subject to the irrefutably true law of diminishing marginal utility. It is this law, which is implied by the axiom of human action, which is at the heart of Mises’s praxeology. As it relates to money, the law of diminishing marginal utility states that an increase in the quantity of money by an additional unit will inevitably be ranked lower (that is, valued less) than any same-sized unit of money already in an individual’s possession. This is because the new money can only be employed as a means for removing a state of uneasiness that is deemed less urgent than the least-urgent uneasiness which one has up to now been removing with the money in one’s possession.

Money Demand

People hold money because money has purchasing power (which people desire, given the fact of uncertainty as an undeniable category of human action), and the purchasing power of money is determined by the supply of and demand for money.

If a rise in the money supply is accompanied by an equal rise in money demand, overall prices and the purchasing power of money remain unchanged. Once people start to exchange their increased money holdings against other goods, however, prices will start to rise, and the purchasing power of money will fall. That said, it is rise of the money supply relative to the demand for money that brings to the fore the obvious effect of an increasing money supply: rising prices.

Mises saw that money demand plays a crucial role for the possibility of an unfolding hyperinflation. If the central bank is expected to increase the money supply in the future, people can be expected to rein in their money demand in the present — that is, increasingly surrendering money against vendible items. This would, other things being equal, drive up money prices. Mises noted that “this goes on until the point is reached beyond which no further changes in the purchasing power of money are expected.”4 The process of rising prices would come to a halt once people have fully adjusted for the expected increase in the money supply.

What happens, however, if people expect that, in the future, the money-supply growth rate will increase to ever-higher rates? In this case, the demand for money would, sooner or later, collapse. Such an expectation would lead (relatively quickly) to a point at which no one would be willing to hold any money — as people would expect money to lose its purchasing power altogether. People would start fleeing out of money entirely. This is what Mises termed a crack-up boom:

If once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size. For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the ‘twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse).5

The Unrelenting Power to Inflate

If people expect a forthcoming, drastic increase the money supply — but if they at the same time expect that such an increase will be limited (i.e., a one-off increase) — the central bank can actually orchestrate a debasing of money without causing its complete destruction. As long as government and its central bank succeed in making people believe that any future rise in the money supply will remain within an acceptable limit, from the viewpoint of the money holder, monetary policy is an effective and most perfidious instrument for expropriation and non-market-conforming income redistribution.

This may explain why Murray N. Rothbard, in his famous essay The Case for a 100 Percent Gold Dollar, wrote the following:

I am not saying that fiat money, once established on the ruins of gold, cannot then continue indefinitely on its own. Unfortunately … if fiat money could not continue indefinitely, I would not have to come here to plead for its abolition.6

Rothbard saw the danger that the government-controlled fiat money could be held up and running indefinitely, that it would not necessarily drive itself into a fatal and final collapse. As long as people do not expect that a money supply increase will spin out of control, the central bank is in a position to debase the currency without completely destroying it.

In other words: hyperinflation would be possible without destroying the money completely. The crack-up boom, as Mises pointed out, would unfold only when people come to the conclusion that the central bank will expand the money supply at ever-greater rates:

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.7

Debt Levels

Today’s fiat-money regimes are characterized by ever-greater amounts of debt relative to real income — caused by policies that try to solve the economic problems caused by credit and money creation out of thin air by using even greater amounts of credit and money created out of thin air. And it is fair to say that the higher an economy’s overall debt level is, the more likely hyperinflation becomes.

To show this, let us assume that after a long period of money creation through bank circulation credit expansion a credit crisis emerges: Creditors are no longer willing to roll over maturing debt at prevailing interest rates. Borrowers cannot repay their obligations when payment is due, and neither can they afford paying higher borrowing costs. Investors start fleeing out of bonds, making interest rates increase sharply and thereby covering up unprofitable investment. More borrowers, including banks, fail to meet their obligations, and bankruptcies spread. Ensuing recession and rising unemployment aggravate the collapse of the credit structure.

Should investors in such a situation expect that the government and its central bank would opt for bailouts financed through additional money creation, the demand for money and fixed claims would most likely dry up. This would make it necessary for the central bank to extend ever-greater amounts of money to struggling borrowers in order to prevent the spread of bankruptcies. The larger the amount of outstanding debt is, the larger will be the potential increase in the money supply. The more the money supply grows, the more likely it is that there will be hyperinflation and a potential breakdown of money demand: the unfolding of a crack-up boom.

• 1. Ludwig von Mises, Memoirs (Auburn: Ludwig von Mises Institute, 2009), pp. 63–64.
• 2. The exchange rates are taken from “Dollarkurs und Goldmark im Verhältnis zur Papiermark 1918–1923,” Wirtschaftsverlag Nerchau (no publishing date).
• 3. For an instructive and highly informative study on the German hyperinflation, see F.D. Graham, Exchange, Prices, And Production in Hyper-Inflation: Germany, 1920–1923 (New York: Russell & Russell, 1967 [1930]).
• 4. Ludwig von Mises, Human Action: A Treatise on Economics, The Scholar’s Edition (Auburn: Ludwig von Mises Institute, 1996), p. 427.
• 5. Ibid.
• 6. Murray N. Rothbard, The Case for a 100 Percent Gold Dollar (Auburn: Ludwig von Mises Institute, 2005 [1962]), p. 149.
• 7. Mises, Human Action, p. 428.