The roots of hyperinflation

IN a country where the annual inflation rate is in four figures, the previous month can seem like a golden age. Venezuela’s currency, the bolívar, has lost 99.9% of its value in a short time. It is hard to fathom how a government can get its economic policy so wrong when the effects of hyperinflation are so severe. What are its causes?

Start with a definition. In 1956 Phillip Cagan, an economist working at America’s National Bureau of Economic Research, published a seminal study of hyperinflation, which he defined as a period in which prices rise by more than 50% a month. The phenomenon is rare. Steve Hanke, of Johns Hopkins University, and his colleagues have documented 57 cases, of which Venezuela is the most recent. Often the backdrop is revolution, war or political transition. The first recorded episode occurred between 1795 and 1796, in revolutionary France. There was a cluster of hyperinflations in Europe after the first world war, notably in Germany, and in the early 1990s in countries affected by the break-up the Soviet Union. Yet war and revolution are not always the setting, as the recent cases of Venezuela and Zimbabwe show.

Though each episode of hyperinflation has its unique miseries, there are common patterns. Often the economy concerned will already have a chronic weakness. Usually it is an underlying fiscal problem. There might be pressure on the budget from, say, the cost of prosecuting a war, or from welfare spending or from looting by officials. Tax revenue may rely heavily on a single commodity. Frequently the local currency is pegged at an over-valued rate, which keeps inflation hidden for a while, only for it to show up suddenly. The problems begin with a “shock” to the economy. It might be a slump in oil prices, as in the case of Venezuela, or a slump in farming output, as in the case of Zimbabwe. The shock sets off a chain of events. Tax revenues evaporate, leaving a hole in public finances. The government fills it by printing money. The increase in the supply of money pushes up inflation. That is bad enough. But what accelerates this process, turning a jump in prices into hyperinflation, is the impact of inflation on government revenue. Because taxes on income or sales are typically paid after they accrue, a period of high inflation leads to a fall in their real value. So the government resorts again to financing its budget deficit by printing more money. That produces yet more inflation, a still-weaker tax take and further rounds of money creation. At some point, the exchange rate collapses. The ascent of inflation quickly becomes explosive, especially in countries where wages and price rises are indexed.

Hyperinflations do not last long. They end in one of two ways. With the first, the paper currency becomes so utterly worthless that it is supplanted by a hard currency. This is what happened in Zimbabwe at the end of 2008, when the American dollar took over, in effect. Prices will stabilise, but other problems emerge. The country loses control of its banking system and its industry may lose competitiveness. With the second, hyperinflation ends through a reform programme. This typically involves a commitment to control the budget, a new issue of banknotes and a stabilisation of the exchange rate—ideally all backed with confidence-inspiring foreign loans. Without such reform, Venezuela’s leaders, though scornful of America, may find that its people are forced eventually to adopt its dollar anyway.

See also:When the prices are too damn high

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