## Wednesday, September 3, 2014

### Krugman's Missing Model

For years Krugman has been posting asking if anyone has a model of how a country that prints its own money can get into trouble from high government debt and deficit.  Here is one quote, but there are many many others:
I find it quite remarkable that nobody has managed to produce a coherent model to justify the seemingly simple story that anyone, even a country that borrows in its own currency, can suddenly turn into Greece. Again, show me the model!
I have the model he is looking for!   Of course when you print your own money the exact failure mode from too much debt and deficit is a bit different but no less dangerous or bad.

First let me quote Wikipedia about economic models, "In economics, a model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using mathematical techniques."  Also, "A model establishes an argumentative framework for applying logic and mathematics that can be independently discussed and tested and that can be applied in various instances."

In my model of hyperinflation there are positive feedback loops.   It is very similar to an avalanche, earthquake, volcano, or forest fire.  Conditions build up that make a chain reaction possible.  It is hard to predict when the chain reaction will start because some small thing triggers the chain reaction.  After starting, the chain reaction happens relatively quickly and with impressive power.   Once started, it is very hard to stop.  Eventually it burns itself out.

There are many different ways to explain the positive feedback loops in hyperinflation.   Different economic theories explain it differently.  There are many good ways to think about hyperinflation.   Here is just one sample from that link:

There can be a feedback loop where the more the central bank makes money and buys bonds the less people want to hold bonds, but the less people hold bonds the more the central bank has to monetize so the government has cash to operate.  This results in a flood of new money and inflation.  The inflation causes the velocity of money to go up.  Governments almost always try to fight inflation with price controls.  The resulting shortages make the real GNP go down.   Using the equation of exchange view of hyperinflation, we can see that if the money supply is going up fast, the velocity of money is going up fast, and GNP is going down, that prices will go up very fast.  Hyperinflation is a triple whammy of inflation.  Of course, the more inflation goes up, the more value bonds lose, so the less anyone wants to hold bonds...

I also have an online simulation showing how hyperinflation works.   It shows how hyperinflation emerges mechanically from macroeconomic processes gone wrong.  This shows 5 different feedback loops with reasonable formulas can quickly go from normal inflation to high inflation.   It uses things like "money supply", "inflation rate", "velocity of money", "interest rate", "GNP", etc.   I think my model is closer to the reality of hyperinflation than any other I have seen.  All the details of the model are well specified so that the computer can run the simulation.   Anyone can easily change the inputs or even the formulas and see how it would change the results.   They are invited to publish their version of the formulas for further argument/discussion.   It is a good model for learning and thinking about how inflation spirals out of control in a country that can print its own money.  This is the model Krugman has been searching for.

I have been unsuccessful in contacting Krugman.  If you know how to contact him, please let him know I have the model he is looking for.

1. I got a \$5 donation via bitcoin today (my first) and that inspired me to write the above. Thanks for the donation!

2. I'm on a quest to find out the biggest historical debt to GDP number that didn't lead to hyperinflation. Right now I've found UK in 1947 at about 240%. If you or anyone of the readers of this blog could find an even bigger number I would be very interested to know! /Thanks Dan

3. The only other one I know that has gotten that large is Japan and I think it is too early to claim that does not lead to hyperinflation. After a big war is over you can cut the military and balance the budget. I really don't expect Japan to be able to balance their budget.

Smaller countries don't get to these levels before things spiral out of control. I don't think any other big country got over this level. So my guess is you have found the winner.

4. Vincent, Nick Rowe has done a series of posts on inflation recently (tailor made for your comments):

1. Thanks. I commented:

2. I'll take a look, but Nick might not: I put them in reverse chronological order, with the newest one at the top. He has a tendency to ignore comments on "stale" posts.

3. ... also in terms of your comment, it looks like it should be for Nick's most recent.