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Posted Thursday 2 October 2003

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Economic Viewpoint
 
Hyperinflation: causes, cures


10/2/2003 8:05:05 AM (GMT +2)

ZIMBABWE is caught up in a devastating era of very high inflation with the figure now pegged at 426.6 percent for August 2003.

The high level of inflation is causing a lot of strife, particularly among poor rural and urban households and those on fixed incomes (pensioners). Fighting inflation should be the number one priority for the government given the economic hardships that it is causing.

Regrettably, there is no serious attempt by the government to address the crisis. In this article, I will outline the causes and cures of hyperinflation and attempt to draw some lessons for Zimbabwe from other countries’ experiences with hyperinflation.

The most widely accepted definition of hyperinflation among economists is that by Philip Cagan who, in his 1956 paper, classified hyperinflation as any inflation exceeding 50 percent per month (or 12 875 percent per year).

According to this definition, Zimbabwe’s inflation would not qualify as hyperinflation. However, the Zimbabwean economy has already assumed features that are similar to those of a country experiencing hyperinflation.


The most spectacular episode of hyperinflation in modern history is that which occurred in Hungary in 1945 and 1946. In its final week, it is reported to have reached a peak of 158 486 percent. In more recent times, Latin American countries have gone through periods of very high inflation, with the worst case being Nicaragua which experienced inflation of 64 000 percent in 1991.

There have been some great debates in the past about money supply growth as the cause of inflation. The majority of economists nowadays accept the strong correlation between money supply growth and inflation. Hyperinflation is simply an extreme case of money supply growth exceeding the growth in the production of goods and services in an economy. Excessive money supply growth occurs because the government spends more money than it collects through taxes and charges, leading to the printing of money to fill the gap between revenue and expenditure.

The excess money that the government creates causes excess demand in the economy leading to an increase in prices. Excess money supply also creates an excess demand for imported products and, where there is a foreign currency supply constraint, this translates into a depreciation of the local currency. The depreciation may be implied or actual depending on the foreign exchange regime that the country operates.

Once inflation has been triggered by excess money supply, it is sustained through various means and, if unchecked, rises to hyperinflation levels.

Does money supply growth cause inflation or is the direction of causation from inflation and exchange rate adjustments to money supply growth? Some economists (for example Fischer, Sahay and Vegh) have done some empirical analyses, which show that causation may run from inflation/exchange rate changes to money supply growth. They argue that once inflation has been triggered, monetary policy becomes accommodative. Inflation then is driven by shocks and its own internal dynamics (inertia, expectations). Thus, the longer an inflation persists, the more difficult it becomes to bring under control.

If the root cause of inflation is so well known, the obvious question to ask is: Why does inflation persist? One reason why inflation persists is inertia. Once inflation has become established, everyone wants to hedge against it by increasing prices. This leads to a wave of price increases that are unrelated to the original excessive money growth.

As inflation rises, workers demand indexation of their wages to inflation. This tends to reinforce the inflation spiral. Once inflation expectations have become entrenched within society, the government may find it too costly not to validate the public’s expectations. It then accommodates inflationary expectations through monetary expansion, thereby fuelling the inflation.

Another explanation for the persistence of high inflation is that provided by Alesina and Drazen (1991) in their famed "war of attrition" model. The two examine an economy experiencing high inflation with two groups of economic agents. Each group is not prepared to act to address the problem of high inflation but, instead, expects the other group to make sacrifices on its behalf in order to bring about stability. This game of "wait-and-see" continues until one group can no longer bear the costs imposed by inflation and decides to give in and make sacrifices in order to bring about stability.

A practical lesson that can be drawn from this model is that things must get worse before they get better. In other words, countries need to go through a hyperinflation crisis before a political consensus for a stabilisation emerges.


Brazil — Brazil experienced a period of very high inflation between 1987 and 1997 during which inflation rose to 2 000 percent. Despite some credible attempts to reduce the budget deficit, hyperinflation in Brazil persisted throughout this period. During the 10-year period, Brazil changed its currency five times, implemented extensive price and wage controls and devalued its currency. All this did not work. What eventually did the trick was:

  • a constitutional amendment in 1994 which empowered the Central Bank not to finance the budget deficit;
  • the Central Bank made it illegal for regional banks to buy government-issued bonds; and
  • wages were frozen and a new currency — the real — was introduced as part of measures to de-index the economy.

As a result of these measures, prices dropped dramatically from July 1994 onwards and by 1997, inflation had been reduced to standard international levels.

Argentina — Hyperinflation exploded in Argentina in 1989 after a chronic inflationary process dating back to 1945. Annual inflation in December 1989 reached 4 923.3 percent. Government expenditure during 1989 reached 35.6 percent of GDP and the fiscal deficit was 7.6 percent of GDP.

In 1990 the Argentine government announced a stabilisation plan which had the following elements:

  • comprehensive liberalisation of foreign trade and capital movements;
  • privatisation of public enterprises and the deregulation of the economy;
  • reduction in the size of the public sector and reconstruction of the tax system; and
  • creation of a new monetary system, including the establishment of a Currency Board in April 1991.

Measures to instil greater fiscal discipline resulted in a reduction in government expenditure to 27 percent of GDP in 1995. Disinflation was gradual, with inflation falling from 1 344 percent in 1990, 84 percent in 1991, 17.5 percent in 1992, 7.4 percent in 1993, 3.9 percent in 1994 and 1.6 percent in 1995.

The law that created a new monetary system included clauses that prohibited indexation. It became mandatory for collective bargaining to be accompanied by agreements on productivity.

Lessons for Zimbabwe

In conclusion, I will highlight some of the lessons that we can draw from the economic literature on hyperinflation as well as the country experiences in dealing with this scourge.

These are:

  • Hyperinflation has its root cause in money growth, which is not supported by growth in the output of goods and services. Usually the excessive money supply growth is caused by financing of the government budget deficit through the printing of money.
  • The political costs of stopping hyperinflation may be high, leading to reluctance by the political leadership to take decisive measures to deal with the problem.
  • Delays in reform may also be explained in terms of a crisis of expectations ("war of attrition") among interest groups where one or several interest groups are not prepared to make sacrifices and, instead, expect others to make sacrifices on its/their behalf.
  • Sharp reductions in the fiscal deficit are always a critical element of a stabilisation programme. It takes time to achieve lower rates of inflation even when the fiscal deficit has been reduced.
  • Apart from money supply growth, hyperinflation is reinforced by its own internal dynamics which include indexation, inertia and expectations.
  • The political leadership has to be prepared to make sacrifices and to take away benefits from vested interests if the war against inflation is to be won.
  • There is no evidence that a stabilisation programme can restore growth within an economy. What is certain is that a stabilisation programme assists in achieving a more stable economic environment.
  • Bernard Mufute is an economist at the Confederation of Zimbabwe Industries. The views expressed in this article do not necessarily reflect those of the Confederation.


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Hyperinflation: causes, cures