According to Milton Friedman, "inflation is always and everywhere a monetary phenomenon."
If that is true, then you have to wonder where the heck all of the inflation is.
Every central bank in the Western world is holding interest rates down, and almost all of them are printing money like it's going out of style.
Five years ago, nearly every economist in the world would have told you this would cause inflation to skyrocket, and the big deficits governments were running would make matters even worse.
Taken together, monetary and fiscal policies are far more extreme than they have ever been.
Yet, inflation has remained rather tame at 2%. In Friedman's world that just wouldn't be possible.
What does it all mean?....
It means even Nobel Prize-winning economists can get it wrong-at least in the short run.
Here's why Friedman has been wrong on inflation so far. It starts with his basic theory.
Friedman's Theory on Inflation
The central equation of Friedman's monetary theory is M*V=P*Y, where M is the money supply, Y is Gross Domestic Product, P is the price level and V is the "velocity" of money, thought of intuitively as the speed at which money moves around the economy.
In this case, the M2 money supply has been increased by 11.5% in the last two months and 8.2% in the past year, while the St. Louis Fed's Money of Zero Maturity (the nearest we can get to the old M3) has increased by 13.1% in the last two months and 8.4% in the last year.
Since GDP is increasing at barely 2%, that ought to mean prices should increase by 6%, just based on the last year's data alone.
Needless to say, that's not happening, since consumer price inflation is under 2%.
Of course, monetarists will tell you that money supply produces inflation only with a lag.
Fine, but it's also true that the M2 money supply has been increasing by 7.4% over the last five years. Admittedly, there was a year in mid-2009-2010 when it stayed flat, but otherwise the monetary base has been increasing at about 8-10% per year.
Again, growth in those five years has been below 2%, and five years is longer than anyone thinks the lag should be. So why isn't inflation at least 5% not 2%?
Monetarists would explain that by telling you that monetary velocity has declined over the last five years.
That's obvious from the equation, but what is monetary velocity and why has it declined?
The velocity of money is simply the average frequency with which a unit of money is spent in a specific period of time. And in our day-to-day activities, it's obvious that monetary velocity has in fact increased.
More people are using debit cards, which cause transactions to move instantaneously from the bank account to the merchant, and many people are using Internet banking, which similarly increases the speed of transactions, reducing both the amount of physical cash carried and the time that old-fashioned checks spend sitting in storage at the U.S. Postal Service.
So what is the problem?
Monetarists will tell you that the decline in monetary velocity is due to the massive balances, over $1 trillion, which the banks have on deposit with the Fed, which just sit there and do nothing.
That's probably correct since while the deposits exist, the ordinary mechanisms of monetary movement simply don't work, since that money has no velocity.
As a result, Bernanke and his overseas cohorts have succeeded in saving themselves from being hindered by a surge in inflation.
The Japanese experience over the last 20 years suggests that this position, with a huge money supply and no inflation, may continue for 20 years or more.
In short, thanks to the banks, Freidman's monetary theory has simply stopped working.
Why Inflation is Headed Our Way Eventually
It's not clear to me whether at some point the banks will start lending the trillion-dollar balances at the Fed, in which case inflation will revive rapidly.
However, there is one other economic theory that is relevant here.
Austrian economists like Ludwig von Mises will tell you that ultra-low interest rates will create an orgy of speculation, in which markets create a huge volume of "malinvestment" - investment that should not economically have been made, and which has less value than its cost.
Eventually-like it did in 1929, the volume of malinvestment becomes so great that a crash occurs, in which all the bad investments have to be written off, huge losses are taken and a wave of bankruptcies sweeps across the economy.
This didn't happen in Japan. The banks went on lending to bad companies, creating a collection of zombies which sapped the vitality from the Japanese economy and has produced more than 20 years of economic stagnation.
In Japan, the politicians have even decided to print more money and do still more deficit spending. Since Japan has debt of 230% of GDP this will almost certainly produce a crisis of confidence, in which buyers stop buying Japan Government Bonds. That will cause the government to default and will more or less shut down the Japanese economy - the worst possible outcome.
Since politicians hate periods of liquidation, they could encourage the same behavior here, in which case growth will continue at current sluggish rates until the Federal deficit becomes so great that nobody will buy U.S. Treasuries.
Again, without a Treasury market, there will be an economic collapse.
At that point, you're likely to get all the inflation you want - it's basically what happened in the German Weimar Republic in 1923.
The point is, Bernanke has created something of a new monetary ground, increasing the money supply rapidly without getting inflation. But it won't last.
At some point we'll get hyperinflation and probably a Treasury default.
For investors the action to take is obvious: Buy gold. At some point fairly soon, you'll need it.
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they spend much more money on luxury items in proportion to food than in 1923. that's means "nonessential" consumer items are counted when working out inflation so when there is less money around they spend a higher proportion on food and less on luxury goods so if food goes up a bit which it has then it does not show up in inflation figures measured on food and all other consumersable what next softly tread the brave. frank
If we do get hyperinflation,why would the Treasury then need to default ?
Martin, do you go to grocery store, or buy your own gas? Do you truly buy into the governments CPI index? When one factors in food, energy, clothing, and healthcare costs, the real nflation rate is 8-10%.
Thank you John. That is what I was about to say. Gas alone has doubled in the last 4 years making an inflation rate of 25% per year. Food prices are astoundingly higher. Beef alone has doubled and the prices of many other items are way up too. These items should be counted in the inflation rate as they are items which are bought daily. The government has lied to the american people much too long.
Gas prices are influenced more strongly by supply and demand fluctuations than by inflation…turmoil in the middle east and 10% annual growth in the developing economies account for nearly all the growth in gas prices.
Food prices are also impacted strongly by supply and demand fluctuations…droughts, blights, and insect infestations often lead to shortages and sharp increases in prices. In addition, economic growth in third-world countries is creating greater demand and putting upward pressure on prices.
In addition, the increasing cost of oil compounds the cost of food because it is used not only to power farm equipment, and shipping, but also to make fertilizer, pesticides, and herbicides. This is why food and energy are excluded from inflation calculations.
John,
You are right on the money!
To say there is no inflation is simply WRONG!. Food, gas, clothes, entertainment, college tuition(rising each semester, I know got 2 in college and one next year), and a multitude of everything else. Anyone that says otherwise should get out of their fantasy world in DC or Wall street and get a real job. Oh and by the way… income in the real world is going down. It is difficult for me to make as much as I did 10 years ago.
ok.. im done… for now
JOHN YOU HAVE IT RIGHT. THE GOVERNMENT TAKES OUT THE COST OF FOOD AND GASOLINE TO GET ITS INFLATION RATE. 4 YEARS AGO A MIDDLE INCOME FAMILY AVERAGED ABOUT $55,000.00 PER YEAR INCOME. TODAY THAT SAME INCOME WILL ONLY BY $50,000.00 WORTH OF GOODS AND SERVICE. THESE ARE GOVERNMENT STATISTICS.
I think it's more like 11-12% , but I agree. Inflation is suppressed so they don't have to pay what they should on "social insecurity" payments……among other things.
The talking is for the big and rich have no inflation.
The 8-10% is the for the small and less. Small and less mornally doesn't count.
Maybe Friedman's formula is correct.
It could be that inflation is measured differently these days.
Mr. Friedman's formula IS correct. MV=PQ. Unfortunately, when the FED prints money, it does not stay in one place…it flows GLOBALLY. Both P (inflation) and Q (GDP) grew with quantitative easing just NOT in the USA!
China experienced rapid growth AND inflation at the same time. Inflation was so bad that food prices DOUBLED within only a few months and the government raised interest rates to 20% and taxed speculative investments to bring it back under control.
The one thing Quantitative Easing has taught us is that investments are NOT being made in the United States. If you want to know where the money is going…follow the inflation.
To whoever;
SGS (Shadow Gov't statistics) correctly points out that the "real" inflation rate is
not 2% (1.7%), but rather 9.4% – December year over year.
When the Gov't. is allowed to define what constitutes a change in the "cost of living"
inflator, we will never have a "worrisome" number because they just revise the way
it is defined to produce the number they want, ala Richard Nixon "We will never have
a recession while I am in office", we will simply re-define "recession" to make sure
we don't (1973).
Anyone who visits the supermarket these days KNOWS we already have a SERIOUS
inflation problem, and the people in office are simply trying to calm us down by telling
us that when we watch our paycheck shrink each time we go to the store, we are
"delusional".
You are on dangerous territory to question the scolarship of Milton Friedman. The equation of exchange (MV = PY) is a tautology and is quite analogous to the ideal gas equation (PV = nRT) where P is pressure, V is volume, n is the number of moles of gas and T the tempurature. If you take logarithms and differentiate, the equation of exchange takes on a more useful form: %P = %M2 – %Y + %V2, where % means percent change of the indicated variable. I just did this for the last quarter of 2012 compared to the same for the previous year. I get the inflation (%P) was 3.5%. Moreover, you did not include the change in velocity in your calculation. The Fed has no direcrt control over M1 or M2. Iti only can increase the monitary base M0). M1 and M2 are related to M0 by the money multipler MM. MM is the result of our fractional reserve banking system. MM is currently less than one where historically it should be around 3. This means we have a broken banking system. The Fed has drastically increase M0, but the money is stuck as excess reserves of the banks. Excess reserves are not part of M1 or M2. That's why inflation has not taken off. Big Ben has cleverly paid interest on on these reserves which deincentivizes banks to lend this money out. But if MM goes back to historic values, watch out! A tsunami of inflation willl roll in.
The money is "stuck as excess reserves…" this is because there is a hostile business environment and it is more profitable to buy-out failing competitors than to make loans. Banks are holding on to the cash for this purpose, and to buy back their own stock in case they are threatened with a hostile takeover.
"WE DON'T HAVE much INFLATION" IS A POPULAR VIEW
Actually, employees ("Candy") at retail grocery stores such as Vons have a serious perception problem that interfers with their judgement and objectivity. In fact, if you mention(ed) the future possibility of much higher food inflation ( Dec. 2010), they just deny the existence of any inflation in their store and view your comment as a joke or sadly misinformed.
In reality, could not be closer to the truth. So far though, we have yet to have the kind of really high inflation that gets everyone's attention and generates the subsequent media talking heads every night. The media will only cover a subject when the audience is sufficienly large enough to get the revenue they need.
Mr. Hutchinson,
As usual, you make some extraordinary salient and fascinating points. Like you, I’m confused about the lack of inflation in spite of all the money printing.
The prices of leather goods I purchase for resale haven’t gone up. The prices of lead crystal I buy for resale haven’t gone up. The price of toys and movie memorabilia I buy for resale haven’t gone up. But it certainly appears that food prices have gone up. Or have they?
On the other hand, the price of homes has gone up, the price of the stock market has gone up, the association fees of my rental property have gone up, and my cable bill has gone up.
But what has gone up the most in the past 30 years? It’s the price of debt. When Paul Volcker instituted a de facto “gold standard” on the dollar by bringing interest rates up to 20% in the early 1980s, investors have been suckered into buying more and more of something that simply isn’t in short supply. Plus, they’ve been willing to pay more and more for it too.
If enormous flows of capital continue moving into instruments that are wasteful and unproductive, the inevitable outcome is stagnation in real economic growth. In exchange for safety, because the economy now has capital misallocations on a scale never experienced, nor anticipated by von Mises or Hayek, investors have diverted their wealth into a bottomless pit. We may have lost at least a generation of productivity because of this. That’s probably why we still aren’t colonizing Mars.
This perverse paradigm could go on for quite a long time, as interest rates remain so extraordinarily low, and the Federal Reserve can continue to purchase government debt if buyers cease to appear.
Here’s the conundrum: What happens when the bond bubble bursts? The longer it doesn’t happen, the worse it will be when it comes.
As I’ve stated here once before, I believe there will be hyperdeflation at velocities never ever seen before. The central bank won’t even be able to print money fast enough to make up for the decline when it takes hold. At the same time, those with any cash or tradable wealth at all will pile into tangibles like real estate, commodities, and anything that they can touch. That will trigger hyperinflation in those assets. It might even cause the stock market to go sky-high—maybe.
After 100 years of Federal Reserve meddling, inflation will try to revert to a natural mean. This will probably be made possible by the confluence of debt hyperdeflation through repudiation (which is money, of course), along with the hyperinflation of everything else. The US dollar will be destroyed.
Yet I remain completely fascinated by Robert Prechter’s prediction that physical dollars will become very valuable in a hyperdeflationary environment. Considering how our physical currency is viewed by everyone around the world due to the brainwashing that’s been wrought due to our status as the world’s reserve currency, could he have a point? I’d be interested to know what you think about Prechter’s idea.
With the advent of Bitcoin, gold-backed credit cards, and other digital currencies, maybe money will flow there?
It’s simply hard to see physical gold being used in a world were money now flows digitally at a much faster rate than physical dollars or gold could be exchanged in an efficient manner if the dollar goes the way of the Dodo.
Any ideas on a timeline?
To put it more simply, If the masses, primarily the middleclass, don't have or get enough money to create the inflation process, there will not be an inflation creation. The super rich and banks have the money under the mattress. Nuff said!!
It is interesting how mattress thicknesses have tripled in the past few years. Fitted sheets now accommodate 18" mattresses.
Dear Dr. Hutchinson,
Thank you for your elucidating article.
Best regards,
Dimi Chakalov
I think inflation is more than 2%. A lot of Dollars are paid or given to other countries, causing inflation there, not here. Rich people are hoarding Dollars, and insiders are stealing Dollars and parking them in off-shore bank accounts.
Thank You; First attempt at explaining the phenomenon that I've ever seen.
"Yet, inflation has remained rather tame at 2%…"
Mr Hutchinson, shame on you for perpetuating this manipulated illusion. As you well know CPI is massaged and contorted by such clandestine methods such as hedonics, weighting and substitutions. The real CPI is of the magnitude of 8-9%. That renders your article all but meaningless.
The reason that we have low inflation is that we have high productivity. As long as the rate of productivity growth is greater than the rate of inflation then inflation is held at bay. The current inflation rate is the net rate. So the underlying inflation is greater than the rate of productivity growth. There are two types of inflation-monetary inflation and economic inflation. Economic inflation is due to short term disruptions in supply and demand in an unencumbered economy. An unencumbered economy is an economy free of taxation, regulation and other forms of coercion in the formation of contracts. Monetary inflation is the result of government fiscal and monetary policies. We are currently seeing mainly monetary inflation. The printing of money by the Fed which is going to buying Treasuries and distressed mortgages from Fannie and Freddie is causing asset values to increase. Thus we have a higher stock market and gradually increasing housing prices. The higher stock prices places pressure on companies to increase earnings to maintain historic and expected P/E ratios. In a no-growth economy companies can only maintain earnings by improvements in productivity. Thus we have high unemployment. Improvements in productivity arise from the tremendous technological progress made in the last 10 to 15 years particularly with the introduction of the computer, cell phone and internet. These technologies improved efficiency in the service industry which accounts for at least 75% of the economy. When the government manufactured financial crises occurred companies took advantage of the new technology and laid off millions of people thus maintaining high earnings. Now the rate of productivity improvement is slowing as is evidence by the smaller number of new unemployment claims. But the printing of money continues and the stock market keeps going up. Companies are having a harder time maintaining P/E ratios in the face of declining revenues. This will become harder as more taxes and regulations start hitting companies. To increase earnings companies will have no choice but raise prices. Combine the effects of last year’s drought which will increase meat prices which is economic inflation with the increase in prices of manufactured goods and services which is the result of monetary inflation as I showed, and general inflation will increase very quickly this year. Many current bond investors including countries like China, Japan and Brazil have purchased long term bonds and short term bonds at interest rates around 2% or lower. At these low rates it takes over 30 years for a principle to double. The number of years for principle to double increases exponentially as interest rates decline below 2%. Thus a small increase in interest rates at these low levels will cause investors to sell there debt in order to preserve principle. Interest rates will go up very quickly to offset the rapid increase in inflation. Bond investors will sell their debt and people will pay off debt rather that refinance. This will cause money to rush out of the stock market and equity prices will collapse. This is what happened in 2000 as the Fed increased interest rates to fight the increase in asset values which in that case had no inflationary effect. Bottom line is that inflation is lurking in the background and it is ready to spring. The more money the Fed prints the tighter the spring is wound and the worse will be the outcome.
I agree with the comments above regarding food, energy, education, & medical prices. Inflation has started to run it's course. In addition, the Fed keeps changing the basket of goods by which they measure inflation to do their best to keep that number low. It's only going to get worse. I think silver is a better bet than gold though.
GOOD AS GOLD ??
Me too. The Federal government will never confiscate silver, as they never yet have. In addition, gold is subject to counterfitting. It can be very difficult for the average gold bug to detect fake gold coins or bullion. Its a serious practical defect. We have no experience as a nation in everyday use of gold as a medium of payment (money).
All parties to a gold transaction must believe YOUR gold is authentic, or you have an illiquid asset. Detailed purity testing or assays are totally impractical for everyday mundane transactions. Gold coins have not been widely used in the United States since the 1920's and few of the people around back then are still alive.
Simply put , you must never have to slum into the supermarket. $5 chickens are now $8 over a two year period. Can you say 60% increase.
I don't think the government inflation # of 2% is anywhere near the actual increase in consumer prices. The actual increase is at least 5 to 6 % which comes close to making the formula more accurate. Government adjusted #'s seem to mostly have a bias in the direction the government wants the public to think things are like or going.
I think you're exactly right. The government keeps changing its market basket. My sewer bill just went up 27% this week, and gas prices have risen 20 cents per gallon in less than 2 weeks.
If the CPI included things you actually have to have, I think even your 5 to 6% inflation is conservative.
It is sad that anyone ever believed Friedman and the monetarists. Obviously everyone here still does despite overwhelming and ongoing evidence that their theories are flat out wrong. One group formed a new school they call "monetary realism" because they debunked so many widely held beliefs just by connecting the dots on how the monetary system really works. "Realism" was the result, for example, of talking to bankers about their operations. They will tell you that they don't check their Reserves before making loans. They are merely tools for inter-bank settlements and nothing more. So the Fed can stuff banks full of quadrillions in reserves and there will be ZERO inflation because banks only make loans when they have credit worthy borrowers walk in the door. If they had zero reserves, they'd make the loan, then get the reserves from the Fed at the end of the month. How many more years of Japanese non-inflation, and US slight inflation, must we go through before smart people like yourself will stop making up excuses for Friedman and actually question is unbelievably flawed beliefs? There are quite a few more myths everyone believes… a dose of "realism" in how money and the monetary system really works is badly needed.
HYPERINFLATION OR HYPERBOLE ??
I get real suspecious when everywhere I turn ( PM Television, paper, internet) you hear "buy gold", the "shadow price is really $10,000/ounce. Well, most of the gold is not in circulation but instead held in various central bank vaults. Even sovereign nations like Germany don't trust the FED to keep custody of their gold anymore. Confidence is breaking down. So something new wlll certainly arise when the time is right.
Exactly at what price the "something else" is exchanged at in your particular currency ( USD or whatever) is another matter entirely. Here is a guess: when inflation picks up it will catch everyone by complete surprise and cause market disruptions like we have not seen since the 1970's. Gold will, of course, remain volatile as will other commodities, as well.
If indeed we have a complete collapse of the U.S. Dollar caused by "hyperinflation" ( 1,000%/ year +) then your dollars will be worth absolute zero. Long before that happens, you won't even be able to get cash because there won't be enough in circulation and the Government can't print new paper money fast enough. In addition, electronic payment systems may fail under these unstable conditions. So, you have some gold. There would be a period of disorder in the transition from the old monetary system to the start of the new one. Can you guard your gold without guns? Can you trade your gold for necessities when stores are burned down, vacant, or just with bare shelves? Can you eat gold?
You better transfer your paper wealth into productive agricultural land while you can. Buy land at home or abroad for a garden, a farm or a ranch and preferably away from any urban areas for safety. Many people won't survive such a crisis and those that do will experience great hardships and deprevation (starvation and disease). Many will die.
I remember seeing something on YouTube where someone had taken four people who had got everything wrong about the economy – ("No one saw this coming."). He compared this with four people who did see it coming. The four who got it wrong had one thing in common, and the four who got it right had one thing in common. The four who got it wrong all used government statistics. The four who got it right ignored government statistics. If the US cost of living has risen 2 percent, then I am the King of Siam.
If one reads your article carefully, I think that everything that needs saying is in there. But would it not have been simpler to explain Friedman's dictum that inflation is a monetary problem. One shouldn't use the word inflation in relation to prices. The supply of money can be inflated; price levels rise and fall and, sometimes, remain stable. Money that is not allowed to come into the market place has no immediate effect on the economy. Money has only an effect on the price level when it is used as purchasing power, and when it's allowed to increase demand prior to an increase in the supply of demanded goods and services.
thank you Robert, but more likely King of Zimbabwe.
it is more simple, the theory has to be economic, not financial:
by transferring the funds of printed money to lower the public debt , instead of redistributing it to the social adjustment to prevent poors from becoming poorer, the inflation goes on slowly, and in the same time, the cost of one human goes down: the system has found his way to pay the richers by taking yet more to the poorers. Inflation will come back when the whole repartition of the benefits of work will be again on the good side, inflation beeing in this now old configuration the way states use to reequilibrate profit against repartition.
No mystery, financial theories are here but smoke not to see all the trees.
Martin,
I think the banks are not "doing nothing" with their reserves. They pledge it as collateral to obtain cash through the Repo market and use it for speculative purposes, largely in the derivative markets, which could turn very rapidly in a malinvestment.
Per your recent article about the "lack of inflation"; Anybody that believes the official 2% rate is true has to be smoking or drinking something hallucinatory!
another convoluted and necessarily confusing/lengthy explanation of why there is no inflation. Friedman studied economies going back literally dozens of centuries. He found that price increase was a symptom of increased money supply in every. single. example. So you think all of a sudden this central law of economics doesn't exist anymore? Stop being a sucker. It's poorly written articles like this that give the BLS an ounce of credit when they deserve NONE. I encourage the author of this article to check out Shadow Stats. There, an Ivy league Econ PHD breaks down the CPI-U, why it's nothing but smoke and mirrors, and exposes the fact that the real CPI (standard of living) is actually closer to the 9-10% range over the last 2 years.
*ounce of validity* is more like it
First of all, you need to use an accurate inflation number. The real inflation number is the one that reflects the ACTUAL RISE IN COST FOR THE AVERAGE PERSON.
When you add in energy and food and healthcare and anything else we have to spend money on…then you will see the true inflation figure. The "government inflation number" is a scam and an outright lie to keep them from having to raise anything tied to inflation, like Social Security.
There they go again! REAL INFLATION! You guys kill me with your your surreal comments. Go shopping for everyday goods and services and SEE what is really going on.You are one of those elitist east coast fabricators of your so called truth. I call that "MENTAL MASTURBATION". You people make up statistics to make yourselves "FEEL GOOD" AND THEN REALLY BELIEVE THAT THE REAL PEOPLE WILL JUST GO BACK TO SLEEP. Well I for one don't believe the average Joe out there is looking what's in his shopping cart and jumping for JOY when he or she gets to the check-out!! Reallity is coming for you guys and when it does I hope that guy or gal that you've been BSing gets to meet you ON THE STREET!!!
Mr. Hutchinson reaches the right conclusion (but for the wrong reasons), and then concludes that “eventually” we’ll see some type of hyperinflation (and trots out the Austrians as some type of proof). Finally he ends with the prediction that “growth will continue at current sluggish rates until the federal deficit becomes so great that nobody will buy US treasuries.”
The author cites Freidman’s monetarist formula MV=PQ in an attempt to explain the mainstream view of inflation. This theory of inflation relied on three things. First, that the central bank can control the money supply. Second, that there was continual full employment so the only way the economy can respond to nominal demand growth (MV) is via price rises and if MV accelerates there will be inflation. Third, that the velocity of circulation was stable. But of course, neither V nor Q (which assumes we are always at full employment and spawned the disastrous concept of NAIRU) are stable, so it means that increases in money supply are not directly linked to increases in prices.
The last point – about demand for US treasury bonds – has so far been proven false. We heard similar predictions in the 1980s during the Reagan deficit era (when the economy was growing and unemployment was dropping) and bond rates fell continuously. It now looks as though our tenuous recovery has stabilized, as OMB is projecting a deficit around $675 billion for 2014. Of course, this is only possible if Republicans are unable to force major budget cuts on the Obama Administration. Another point that should be made here is that government bond issuance is a voluntary activity, and that federal spending is not “financed” in the fiat currency world – by either taxation or bond issuance (a.k.a. “borrowing”).
Finally, is important to separate inflation from food and energy (these are globally demanded commodities, often influenced by events beyond government control such as weather), and use the “core” number when determining the impact of spending.
The only reason there is no inflation is that the weak Eurodollar created a vacuum that is filled with US dollars. As soon as the hole is filled, hyperinflation will start.