Taming Hyperinflation: A perspective from a skeptic of monetarism

My research suggests rapid money supply growth does not cause ordinary inflation. But I want to be clear that hyperinflation is a whole other story.

Original art by @modográfico

As Venezuela settles into the first hyperinflation worldwide in the last decade, I’d like to share some broad thoughts on this subject. To be clear, I am not a Venezuela expert; my research stems from analysis of historical episodes of hyperinflation. Nonetheless, I am contributing this to ensure there can be no confusion arising from my body of research showing that, in normal macro-economic circumstances, rapid money supply growth does not cause inflation.  

Hyperinflation is a very specific economic malady, with defining characteristics beyond simple inflation. In 2012, Steve Hanke and Nicholas Krus of Johns Hopkins compiled a table of all 56 identifiable instances of hyperinflation to that point, including what they consider the first such instance, France in 1796. In their compilation, they used a strict definition of hyperinflation: a price-level increase of at least 50% per month.

A preponderance of these instances occurred in countries in and just after World War I and World War II, countries in South America in the 1980s, and, especially, the countries of Eastern Europe and the former Soviet Union in the early 1990s as they were transitioning to market economies.

Two prevalent factors across these occurrences were the collapse in productive capacity (through war, commodity price collapse or other factors), and an overdependence on imports.

But the defining factor was the inability or severely diminished ability to borrow or sell debt to any third party, especially foreign banks or investors, coupled with very large and recurring government budget deficits, usually on the order of 10% to 20% or in some cases, much more.

Given this large, recurring deficit, and the inability to obtain funding through a third party, a country will resort to one of two things. The first is to sell debt to its own central bank, which that central bank pays for by giving it fiat currency or by making a fiat credit to the government’s account that can be used to make payments. Both are in effect the creation or “printing” of new money. The second is simply printing new, currency that is unbacked by such things as gold, reserves, or debt.

With the proper antidote, hyperinflation can be stopped in a very short period of time, often just days or weeks.

When a country resorts to this strategy, the value of its currency plummets in relation to external currencies such as the dollar. When this happens, the people and institutions that hold its currency scramble to try and sell the currency in exchange for gold of some more stable external currency before the value of that currency tumbles further. This mass selling only weakens the currency further, creating a rapid downward spiral in the value of the currency. Prices can literally increase exponentially. In Germany in the early 1920s prices increased by ten to the power of fifteen.

A large portion of the inflation comes not just from the large increase in currency but from the fact that, with a depreciated currency, the price of imported goods skyrockets. (Imports are often a significant factor in regular inflation as well).

The experience of these 56 countries has shown one other very important thing. With the proper antidote, hyperinflation can be stopped in a very short period of time, often just days or weeks.

The proper antidote is to stop the deficit spending. Jeffrey Sachs, in his book The End of Poverty, reports that Bolivia’s hyperinflation of 1985 was stopped in weeks by the following strategy. The following is an excerpt from that book:

We looked for a package of fiscal measures that could quickly wean the government away from its dependence on Central Bank financing of the deficit. We soon realized in discussions with our Bolivian colleagues and in looking through the books that the budgetary key lay in the price of oil. Government revenues depended heavily on taxes on hydrocarbons, mainly paid by the state petroleum company, YFPB. The YFPB set the price of oil and gasoline (in pesos). Generally, the oil price was changed every few months, so the price of oil fell sharply in comparison with other prices and in terms of the U.S. dollar during the period in which the peso price was held constant. The low price of oil was, in turn, destroying the budget. … Since the government budget depends on oil taxes, the tax base had collapsed. … Whole truckloads of gasoline were being smuggled over the border to Peru. …

We calculated that if the price of gasoline (and other fuels) was raised around tenfold, back to the world price of around $0.28 per liter, this increase itself would close most of the budget deficit. A package of other measures on the spending and revenue side could close the rest. …

The program was initiated on August twenty-ninth, starting with a sharp rise in oil prices. … The sudden end to the budget deficit led to an immediate stabilization of the exchange rate. … Within a week, the hyperinflation was over. …

Additional steps were required to consolidate the victory over hyperinflation, especially the restructuring of its foreign debt.

So the antidote formula is this:

  1. Close the budget deficit through whatever means required: tax reform, debt restructuring, expense reduction, or even, as in Bolivia, a technical adjustment of commodity prices.
  2. Discontinue printing new money through either means described above. In some cases, this has been achieved by the issuance of a second currency where the commitment not to print additional currency is more credible.
  3. Or make a commitment to do #1 and 2 above that is believed by the market and the citizenry, and then followed up appropriately.

Interestingly, as noted by Thomas Sargent of the Minneapolis Fed in his 1981 paper “The Ends of Four Big Inflations’,” the money supply often rises rapidly in the months and years after hyperinflation. This lends support to the idea that inflation is not simply a function of an expanding money supply, but also or instead a function of other factors.

Richard Vague

Richard Vague is managing partner of Gabriel Investments, chair of The Governor’s Woods Foundation, and author of The Next Economic Disaster, a book on the global economy, as well as a number of articles on economic theory. He was co-founder and CEO of Energy Plus, and also co-founder and CEO of two consumer banks, First USA and Juniper Financial.