Powerful to Worthless: Hyperinflation
- Sarah Baek
- Sep 5, 2021
- 3 min read
Updated: Dec 10, 2021
In a world where we use the fiat currency, the loss of people’s trust in a currency results in traumatic experiences. One of them is hyperinflation. In The Monetary Dynamics of Hyperinflation, Philip Cagan had defined a hyperinflationary episode as when monthly inflation rate exceeds 50%.
So far, there are 57 documented cases of hyperinflation, the most famous ones being Hungary and the German Weimar Republic’s currency reaching 1020 pegno in 1946 and 1014 marks in 1923, Zimbabwe’s dollar and Venezuela’s bolivar experiencing peak monthly inflation rate at 7.96 x 1010% in 2008 and 234% in 2018.
In a hyperinflationary episode, situations out of comic books become true — when a person tried to pay money for some tissues as the toilet had none, he said to wipe with the money. When Hungary experienced the most destructive inflation in history, all the money in the market combined could only buy 13 pieces of tissues. The tissue has more accepted value in the market, and this fiat currency is no longer accepted in society.
Historically, a war or political transition was often the backdrop of hyperinflation. However, this does not explain the recent cases of hyperinflation in Zimbabwe and Venezuela.
Roots of Inflation by The Economist points to an underlying fiscal problem as the chronic weakness of these two countries. Such pressure could be from prosecuting a war, excessive welfare spending, tax revenue dependent on a single commodity, and/or local currency pegged at an over-valued rate.
It first begins with an exogenous shock to the economy. For Zimbabwe, it was a slump in farming output, and a slump in oil prices for Venezuela. Then it’s a chain of events that destroy people’s trust in their local currency.
Because the government’s tax revenue is dependent on a single commodity, tax revenue evaporates once farming output decreases and oil prices decrease. Then, in order to fill the hole in public finances, the government prints money. Under the quantity theory of money (MV = PT), an increase in the supply of money raises inflation. However, inflation decreases the real value of tax revenues, so the government prints even more money.
From this point on, inflation occurs at a faster rate than the government can print the money. With several more rounds of such printing as the tax revenue is still weak, the exchange rate soon collapses and inflation becomes explosive.
Whether the actual cause was a war, political transition, all eventually lead to a loss of people’s trust in the government (and central bank), the issuer of money, who prints excessive amounts of money. Thus the overarching cause of hyperinflation is the falling trust in currency. Simply put, hyperinflation occurs when people do not feel safe holding onto the currency.
However, the good news is, hyperinflation does not last long, under the right conditions.
The ‘right conditions’ refer to a reform, often with an external help. Examples include a commitment to a new monetary framework, a stabilised exchange rate, mostly through an exchange-rate peg, and a credible pledge to stop funding the government via seigniorage.
Also, a new political regime can help. In 1985, the new Bolivian government, after 3 years of hyperinflation, raised taxes, cut public investment, and ended interest payments. With restored fiscal balance, the exchange rate soon stabilised against the dollar as well. This programme had flipped a five-digit inflation rate to a deflation within a month.
Also, the local currency may be redenominated with a hard currency, also known as a safe haven currency, most likely the USD. This is what Zimbabwe had done in 2009 — the government ceased printing Zimbabwean dollars, which solved the chronic problem of the lack of confidence in the Zimbabwean dollar. However, the country lost control over its banking system and its competitiveness decreased.
Given such traumatic experiences, all countries refuse another episode, or one to begin with.
It is unlikely a monetary problem that causes hyperinflation; rather low competitiveness, high budget deficits, high levels of national debt, and weak financial systems, which are unlikely to be overcome by monetary policy. Such weaknesses must be combated with structural reforms and only a responsible government can achieve this, to establish a strong trust in its currency.
Return of the hyperinflation in Zimbabwe in 2019 when the country converted from foreign currency to a new Zimbabwean dollar, indicated that people’s trust in the Zimbabwean government, central bank, and economy were not restored. As much power as money holds in our lives, we should prevent it from becoming worthless.
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