A Reflection on Hyperinflation


Read and then think with your eyes closed:

You are hungry. So you skip over to the nearby store, browse, and finally buy a packet of biscuits, which in turn satisfy and satiate you partially with their soft, crunchy, chocolate chips, embodied in puny and miniscule biscuits. So you go back again. Buy again. Pay again. But, hey, there’s a mistake here Mr. Manager. I have bought one and not two packets. I can see that sir, he morosely replies. Then why am I paying for two? Oh THAT, that is because the prices doubled overnight.

Now open your eyes, laugh at me, ridicule me. Ho-Ho, Heh-Heh, very funny. So this young economist has come up with his idea of an insipid economic joke, you grind your teeth and mutter under your breath.

I beg your pardon sirs and madams.

The situation highlighted above is a very simplified, but not an untrue picture of a reality that has been pervasive in many countries over the years, and still is in some today. It is a reality of soaring prices, a crash in purchasing power of the local currency and a complete loss of faith in the monetary system. It is a reality where people buy goods to get rid of money and not for their own sake, where the value of currency as paper exceeds its value as money and where all semblance of a stable economic system disappears and chaos reigns supreme. It is the stark picture of HYPERINFLATION.

Hyperinflation as a phenomenon is broadly, paint-brushily defined as a very rapid rise in prices. According to Cagan, hyperinflation is said to be present when the rate of inflation rises to 50 per cent per month in the economy i.e. prices double every 51 days. However, this definition is, but a diligently followed benchmark. Examples of prices rising at stupendous rates abound: Germany (prices doubling in 49 hours-1920s), Greece (prices doubling in 28 hours-1941-44) and Hungary (prices doubling every 15 hours-post WWII). It does not require intellectual insight into the figures to realize that our fanciful, biscuit joke might well have been a not-so-hilarious normal occurrence here.

The evergreen but a tad unnerving concept of “vicious cycle” applies well to hyperinflation, whereby the completion of each cycle leads to a further price-rise, along with a rapid devaluation of the local currency. People start fretting and get panicky upon realizing the sheer futility of having lots of money and yet not being able to buy a single cup of tea the next day, unless they spend hundreds, or maybe, thousands. This results in a knee-jerk reaction, where the citizenry keeps its wealth in the form of real assets or some stable foreign currency. In fact, the immediate advent of hyperinflation can be predicted by the people’s behavior. They’ll either start spending as if there’s no tomorrow or start investing in and hoarding real, non-monetary assets and switching over to some foreign currency, or, in an understandable fit of utter insanity, burn currency notes to supply fuel to the chulha, as the useless notes won’t buy much LPG anyway.

Also, there have been various instants of an entire country using a foreign currency as their own, a process known as dollarisation, due to excessive dip in the purchasing power of the local currency. This was witnessed in Ecuador, where the US $ was adopted in 2000. Others follow a more nationalistic approach. They start printing exorbitant prices on their old, useless notes to make up for the price rise, which is obviously, only a symbolic and not economic solution. So we had Germany printing notes worth 50 million marks and Hungary with ones of 1 million lira! Others may revalue their currency, i.e. slash zeroes from the old currency, as happened in Mexico (1 new peso=1000 old peso), and more recently, in Zimbabwe (3 zeroes slashed).

The different causes cited for the phenomena are like rail tracks converging at a single, dreary junction of hyperinflation. According to the classical and neoclassical branch of economics, the rapid rise in prices is caused due to the rapid, uncontrolled expansion of money supply in the economy by the irresponsible state itself, which is desperately trying to fund its expenses and earn revenue through seignorage (revenue generated upon printing new currency-it is the difference between the face value of the currency and its cost of production per se by the monetary authority) and inflation tax (the economic costs incurred by cash-holders due to price rise). The increased money in the economy leads to fast growth of aggregate demand, without the corresponding increase in the supply. This pushes the prices up and devalues the currency. To correct this “high price” problem, the government prints more money to make its citizens richer, which in turn further fuels price rise till a situation is reached where the oh-so-valuable money printed by the state becomes a burden on the citizenry which they want to get rid of. Thus the vicious cycle continues.

The other reason put forth, this time by the neo-liberalists is a crisis of confidence in the monetary system and a fear that there may be no store of value which the currency would be able to demand in the future. This usually stems from a calamity faced by the country in the form of civil unrest, war, depression etc, where the credibility and solvency of the monetary base gets eroded, resulting in a loss of faith in the currency on a large scale. This result in sellers demanding higher premiums on the original costs of goods for accepting the currency, in view of the risk involved in the currency becoming valueless. The higher premiums further the fears regarding the future of the currency, thereby raising the premiums even higher. Thus a never-ending route is created where higher premiums force the state to create more money for payment of these premiums, eventually leading to the labyrinth that is hyperinflation.

There is no doubt in anybody’s mind that unlike inflation, which is deemed healthy for a growing economy, hyperinflation is destructive to say the least. It distorts the economy in favour of extreme consumption or hoarding assets, renders the savings of public and private sector useless and discourages investment. Thus, countries afflicted by this problem try to remedy it as soon as possible. Various measures are followed. The economy may form a currency basis to oversee issuing of currency only to the extent of the amount of foreign reserves available. Or it may go back to the ancient barter system itself instead of the more viable option of using gold or a hard currency (stable foreign currency in which investors have confidence). Gold is used because everyone knows that no amount of economic trade can change its chemical composition, can it? It was gold, and will remain so, and hence could buy you some bread which the defunct money won’t.

However, the most dynamic and effective, and also perhaps the most risk-ridden way to end hyperinflation is to push the economy into recession. Here the government withdraws its presence from the market by minimizing its expenditures, and allows aggregate demand to fall to extremely low levels in order to check the sky-high prices. This naturally leads to a drastic rise in unemployment levels and poverty, which may cripple the standard of living of the people in the country for years to come, as happened in Russia in the post-Soviet era under Boris Yelstin. Thus, this measure can be seen as the swimmer choosing the deep sea to the devil incarnate. Due to its innate capacity to cause widespread, long-lasting damage to the economy, even after the hyperinflation pest has been hopefully taken care of, this approach is fittingly called shock therapy.

To the critics of capitalism and market economies, it is a constant pinch to realize time and again that most of the countries struck by hyperinflation were communist at the time-Russia, Yugoslavia, Bolivia etc. However, before branding me a communist, it should also be pointed out that economies of non-communist countries like Brazil and Argentina have also faced hyperinflation. The reason cited for the above correlation between communism and hyperinflation is a drastic inefficiency in the economy attributed to excessive governmental control and absence of the price discovery mechanism.

And now we Indians are the latest victims. Prices are going through the roof-top. Companies are reducing the amount they pack in their products, so that the inflation does not show. Yet, it shows, and how!

Arjun Upmanyu

[Image Source:http://www.flickr.com/photos/zzathras777/821842509/]