hyperinflation

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The 1920s German inflation

A 1000 Mark banknote, over-stamped in red with 1,000,000,000 (1 billion) mark, issued in Germany during the hyperinflation of 1923

The hyperinflation episode in the Weimar Republic in the 1920s was not the first hyperinflation, nor was it the only one in early 1920s Europe. However, as the most prominent case following the emergence of economics as a science, it drew interest in a way that previous instances had not. Many of the surreal economic behaviors now associated with hyperinflation were first documented systematically in Germany: order-of-magnitude increases in prices and interest rates, redenomination of the currency, consumer flight from cash to hard assets, and the rapid expansion of industries that produced those assets.

Postage stamps of Weimar Germany during the hyperinflation period of early 1920s

It is sometimes argued that Germany had to inflate its currency to pay the war reparations required under the Treaty of Versailles, but this is only part of the story. Reparations accounted for about one third of the German deficit from 1920 to 1923 (Costantino Bresciani-Turroni, The Economics of Inflation. London: George Allen & Unwin, 1937. p. 93). Nonetheless, the government found reparations a convenient scapegoat. Other scapegoats included bankers and speculators (particularly foreign). The inflation reached its peak by November 1923, but ended when a new currency (theRentenmark) was introduced. The government stated this new currency had a fixed value, and this was accepted.

Hyperinflation did not directly bring about the Nazitakeover of Germany; the inflation ended with the introduction of the Rentenmark and the Weimar Republic continued for a decade afterward. The inflation did, however, raise doubts about the competence of liberal institutions, especially amongst a middle class who had held cash savings and bonds. It also produced resentment of Germany's bankers and speculators, many of themJewish, whom the government and press blamed for the inflation.

Models of hyperinflation

A 1,000,000 (1 Million) Lira banknote, issued by Turkey. The Lira was replaced by the New Turkish Lira in 2005, at 1 million old Lira = 1 New Lira

A 500,000 Cruzeiro banknote, issued by Brazil in 1993. If exchanged, would be worth R$ 0.18 in 1994. Every few years the currency was renamed, and three zeros dropped from the bank notes. A 1960s Cruzeiro is now worth less than one trillionth of a US cent, after adjusting for multiple devaluations and note changes.

A 100,000 Ukrainian karbovanets(used between 1992 and 1996). In 1996, it was taken out of circulation, and was replaced by the Hryvnya at an exchange rate of 100,000 karbovanzi = 1 Hryvnya (approx. USD 0.50 at that time, about USD 0.20 as of 2007). This translates to an average inflation rate of approximately 1400% per month during between 1992 and 1996

Since hyperinflation is visible as a monetary effect, models of hyperinflation center on the demand for money. Economists see both a rapid increase in the money supply and an increase in the velocity of money. Either one or both of these encourage inflation and hyperinflation. A dramatic increase in the velocity of money as the cause of hyperinflation is central to the "crisis of confidence" model of hyperinflation, where the risk premium that sellers demand for the paper currency over the nominal value grows rapidly. The second theory is that there is first a radical increase in the amount of circulating medium, which can be called the "monetary model" of hyperinflation. In either model, the second effect then follows from the first — either too little confidence forcing an increase in the money supply, or too much money destroying confidence.

In the confidence model, some event, or series of events, such as defeats in battle, or a run on stocks of the specie which back a currency, removes the belief that the authority issuing the money will remain solvent — whether a bank or a government. Because people do not want to hold notes which may become valueless, they want to spend them in preference to holding notes which will lose value. Sellers, realizing that there is a higher risk for the currency, demand a greater and greater premium over the original value. Under this model, the method of ending hyperinflation is to change the backing of the currency — often by issuing a completely new one. War is one commonly cited cause of crisis of confidence, particularly losing in a war, as occurred during Napoleonic Vienna, and capital flight, sometimes because of "contagion" is another. In this view, the increase in the circulating medium is the result of the government attempting to buy time without coming to terms with the root cause of the lack of confidence itself.

In the monetary model, hyperinflation is a positive feedback cycle of rapid monetary expansion. It has the same cause as all other inflation: money-issuing bodies, central or otherwise, produce currency to pay spiralling costs, often from lax fiscal policy, or the mounting costs of warfare. When businesspeople perceive that the issuer is committed to a policy of rapid currency expansion, they mark up prices to cover the expected decay in the currency's value. The issuer must then accelerate its expansion to cover these prices, which pushes the currency value down even faster than before. According to this model the issuer cannot "win" and the only solution is to abruptly stop expanding the currency. Unfortunately, the end of expansion can cause a severe financial shock to those using the currency as expectations are suddenly adjusted. This policy, combined with reductions of pensions, wages, and government outlays, formed part of the Washington consensus of the 1990s.

Whatever the cause, hyperinflation involves both the supply and velocity of money. Which comes first is a matter of debate, and there may be no universal story that applies to all cases. But once the hyperinflation is established, the pattern of increasing the money stock, by which ever agencies are allowed to do so, is universal. Because this practice increases the supply of currency without any matching increase in demand for it, the price of the currency, that is the exchange rate, naturally falls relative to other currencies. Inflation becomes hyperinflation when the increase in money supply turns specific areas of pricing power into a general frenzy of spending quickly before money becomes worthless. The purchasing power of the currency drops so rapidly that holding cash for even a day is an unacceptable loss of purchasing power. As a result, no one holds currency, which increases the velocity of money, and worsens the crisis.

That is, rapidly rising prices undermine money's role as a store of value, so that people try to spend it on real goods or services as quickly as possible. Thus, the monetary model predicts that the velocity of money will riseendogenously as a result of the excessive increase in the money supply. At the point where ordinary purchases are affected by inflation pressures, hyperinflation is out of control, in the sense that ordinary policy mechanisms, such as increasing reserve requirements, raising interest rates or cutting government spending will all be responded to by shifting away from the rapidly dwindling currency and towards other means of exchange.

During a period of hyperinflation, bank runs, loans for 24 hour periods, switching to alternate currencies, the return to use of gold or silver or even barter becomes common. Many of the people who hoard gold today expect hyperinflation, and are hedging against it by holding specie. There is, also, extensive capital flight or flight to a "hard" currency such as the U.S. dollar. These are sometimes met with capital controls, an idea which has swung from standard, to anathema, and back into semi-respectability. All of this constitutes an economy which is operating in an "abnormal" way, which may lead to decreases in real production. If so, that intensifies the hyperinflation, since it means that the amount of goods in "too much money chasing too few goods" formulation is also reduced. This is also part of the vicious circle of hyperinflation. ...