The dangers of inflation - Hyperinflation

By Prof. Samie A SayedLME, BSBA, MBA, MCOM

What is hyperinflation?

Zimbabwe Hyperinflation

What is hyperinflation?

• When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money.

• When associated with wars, hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath.

• Hyperinflation causes prices of goods and services to increase, as the currency loses its value.

• Zimbabwe and Bolivia are two very good examples of hyperinflation in the last few decades.

The case of Zimbabwe

• Zimbabwe suffered the second worst hyperinflation ever, second only to World War 2 affected Hungary.

• Zimbabwe monthly inflation hit 50% in February 2007 and hit a peak of 98% daily inflation in November 2008.

• In 2009, Zimbabwe stopped filing monthly inflation figures and abandoned its currency.

• Till 2011, Zimbabwe has not yet introduced its own currency.

• Root cause - Hyperinflation

Zimbabwe Dollar – The background

• In 1980, Zimbabwe became and independent country and Zimbabwe $ was introduced at par value to US$.

• Post a decade of growth, Zimbabwe entered the 1990’s with land reforms headed by dictator Robert Mugabe.

• The three major reasons associated with hyperinflation are –civic unrest, unstable governments and lack of fiscal discipline – and all three were evident in Zimbabwe.

• 1990’s laid the foundation to the hyperinflation era of in the 2000’s and the hyperinflation peaked out in November 2008.

Civic Unrest• Since 2000, President Robert Mugabe introduced a bill which would

enable the government to seize farmlands owned by white farmers. • The government targeted more than two-thirds of the land owned

by whites - some 4,600 farms - for confiscation. • Robert Mugabe continued with his forced land reforms despite

global disapproval – the US Senate approved and passed on to Congress a bill that threatens sanctions unless the Zimbabwean Government respects democratic rule and law and order, and carried out a legalised land reform programme.

• The violent land reform program destroyed the agricultural sector in Zimbabwe and in particular the tobacco industry which accounted for one-third of Zimbabwe's foreign exchange earnings. The manufacturing and mining sectors also suffered great declines.

Unstable Government

• The unstable Government of Zimbabwe led by Robert Mugabe was known for massacring citizens, controlling the media, and perpetuating corruption within the government.

• According to Transparency International Zimbabwe's government ranks 134th of 176 in terms of institutionalized corruption. This corruption directly affected the country causing instability and negative economic effects.

• Instead of instituting constructive policies, the government continued to spend and print money.

• The corrupt and unstable government played a critical role in destroying investor confidence in the Zimbabwe $.

Fiscal Situation

• Besides having internal conflicts and corruption, Robert Mugabe’s government was also involved in the Second Congo War- a war which was fought for control of diamond mines.

• The government kept printing money primarily to pay the salaries of army officials fighting the war as the involvement in the Second Congo War cost millions of Zimbabwean $’s a month.

• The Government of Zimbabwe struck a JV with Congo Government for diamond and gold mines to serve as payment for involvement.

• It has been rumoured that diamonds and the revenue from the mines have been funneled into the corrupt government purse or former soldiers have illegally removed diamonds from the mines

An observation

• Most of the cases of extreme hyperinflation discussed had one thing in common – all were affected by political unrest. – Hungary – World War 2– Zimbabwe – Civil War on land reforms– Yugoslavia – Bosnia– Germany – World War 1

• This clearly calls into consideration that civil unrest and unstable governments could lay the seeds of hyperinflation.

The Case of Bolivia

• In Latin America, five major hyperinflation events occurred in the last two decades of the 20th century – Bolivia, Nicaragua, Peru, Argentina and Brazil.

• Bolivia was one of the first examples of hyperinflation in Latin America and their case is noteworthy because it was able to handle the situation successfully.

• Also, Bolivia is one example where political unrest related to war or revolutions were not responsible for creating hyperinflation.

• Between April 1984 and September 1985, monthly inflation rate was 182.8% and the yearly inflation was recorded as 25,000%.

The Case of Bolivia

• The Bolivian hyperinflation had its roots in weak fiscal budgets. • Inconsistency in conducting unsustainable macroeconomic

policies was an important cause that contributed to widespread capital flight in the 1970s and 1980s in Bolivia.

• Bolivia suffered from major external shocks, including the rise in world interest rates in the early 1980s (the shifting in the US monetary policy), the cut-off in lending from the international capital markets, and the decline in world prices of Bolivia’s commodity exports.

• But the extend of economic collapse in the face of theses shocks suggested that internal factors as well have been critical to Bolivia’s economic performance.

The Case of Bolivia

• Even though budget deficit rose dramatically as a result of increase in cost of servicing foreign debt, Bolivia had already been running a large deficit.

• By1980 Bolivia was already a highly indebted country – the debt-to-GDP ratio was 76 percent increasing to 111.8 percent in 1983 and to 111.9 percent in 1984.

• Most of the Bolivian external debt was related to the rapid growth of public mega-investment projects, which in turn were linked to a complex of political to and economic factors failing in the end to pay the necessary returns.

Economists View

• Five Possible reasons for Hyperinflation in Bolivia– short time horizon of Bolivian governments– the use of state enterprises as a vehicle for political control– the use of state enterprises as a conduit to monitor

investment projects– the overvaluation of the exchange rate, which led to a

misallocation of investment spending into highly capital intensive projects and which increased the budget deficits of the public enterprises

– the use of state enterprises as buffers for macroeconomics shocks

A note on Stagflation

• An economists nightmare : Stagnant or slow growth economy coupled with increasing inflationary pressures.

• Two prime reasons for Stagflation :– productive capacity of an economy is reduced by an

unfavorable supply shock, such as an increase in the price of oil for an oil importing country. Such an unfavorable supply shock tends to raise prices at the same time that it slows the economy by making production more costly and less profitable.

– Excessive money supply coupled with high government regulation of human and capital resources

• Global Stagflation 1973

Lessons for India

• Civic Unrest and Unstable Governments are two often cited reasons for hyperinflation. Corruption is a ticking time bomb which needs to be tackled at the earliest.

• FDI has critical role to play if India has to grown and unstable or corrupt government will force foreign investors to retreat investments from India.

• Hyperinflation / Stagflation could be avoided by having more faith on private investment and productivity rather than government controlled public sector units.

• RBI and Finance Ministry have to ensure that fiscal bills remain under control or the consequences could be severe. So far, RBI had done a good job in managing our currency.