No macroeconomic indicator has as much impact on society as hyperinflation
High inflation has been the talk of the town. In June, US retail price inflation was 9.1%, its highest level in more than four decades. In Turkey, inflation in June was 78.6%, the highest in more than two decades. Inflation has become a reality in countries around the world and is proving difficult to eradicate.
No macroeconomic indicator has as much impact on society as inflation. Most people don’t follow their country’s economic growth numbers but start to feel the pinch as soon as prices start to rise. Inflation is the rate of price increases.
Therefore, it becomes very important to understand the causes of inflation, their impact on society as a whole, and what can possibly be done to control it.
The best way to look at the present is to look at the past. To do this, we will focus on two historical episodes of inflation.
German hyperinflation of 1923 and high inflation in the United States in the late 1970s and early 1980s.
These two different episodes of inflation will help us understand the reasons for inflation as it prevails in the world at large today and what can possibly be done about it.
The classic gold standard
Prior to 1913, most countries in the world used the classic gold standard. This monetary system was different from the monetary system as it prevails today.
Currently, the currency we use is basically fiat currency. It’s money because the government says so. This money is not backed by gold or any other commodity.
But before 1913, each monetary unit was worth a certain amount of gold, and it could be exchanged for gold.
When World War I started, many countries suspended the gold standard so they could print enough money to finance the war. The gold standard did not allow them to print money simply because when the printed money was spent, people could show up at banks to demand that it be converted into gold. Given this, banks and governments may soon run out of gold.
After World War I was over, governments attempted to return to the gold standard. But a country like Germany, which was on the losing side, was in bad financial shape and, at the end of the war, had a budget deficit of 11,300 million Deutsche Marks. The budget deficit is the difference between what a government earns and what it spends.
What happened next ?
Since the government was not earning enough revenue to meet its expenses, it began printing money to fund the expenses. In 1922, one trillion Deutsche Marks were printed as the deficit exploded. In the first six months of 1923, nearly 17 trillion Deutsche Marks were printed.
With so much money printed, German money began to lose its value dramatically. In August 1923, a dollar was worth 620,000 Deutsche Marks and in early November it was worth 620 billion Deutsche Marks. The price of basic necessities has skyrocketed.
The industry that flourished during this time was the ticket printing industry.
A total of 30 paper mills and 133 printing houses were operating, but still could not print enough money to meet the amount needed.
On October 23, 1923, a statement issued by the German central bank indicated that it had been able to print only 120 quadrillion (120 followed by 15 zeros) of paper marks, when demand had been one quintillion (one followed of 18 zeros). Inflation in Germany, at its peak, reached 1,000 million percent.
What was its impact on German society?
Virtually all the money had become worthless. A wheelbarrow full of money was not good enough to buy a newspaper. Walter Levy, a highly respected German-born oil consultant working in New York, would later recall that his father had taken out an insurance policy in 1903. He had religiously paid the premiums for the 20-year policy. When politics matured in 1923, the money he received was just enough to buy a loaf of bread.
As money lost its value, barter came into the picture. Farmers who did not need money urgently chose not to sell their produce to city dwellers. All in all it was a big mess. As money lost value at a rapid rate, men and women ran to spend their wages as soon as they were paid. Businesses had to employ people to count money.
In the end, the paper money had depreciated so much that it was simply used as wallpaper or even used as fuel to generate heat.
Germany decided to switch to a new currency and called it the Renten mark. A Renten mark was worth a thousand billion Reichs. Soon prices stabilized and hyperinflation ended.
The Rise of Hitler and World War II
German citizens lost faith in the politicians and political system of the time as they watched their lifetime savings dwindle to zero. Unemployment among union members rose to 30% in 1923, from less than 1% the previous year. People began to feel a sense of hatred and a loss of faith in the politicians of the time and in the German democratic system.
This paved the way for the rise of Adolf Hitler. As Henry Hazlitt, an American journalist, wrote in What You Should Know About Inflation: “It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.
Hitler led Germany into World War II, which began in 1939 and lasted until 1945. As World War II was about to end, the global financial system was once again in tatters. The financial system that emerged after World War II had the US dollar at its heart. And the greenback was the only currency that could be converted into gold, but only by the central banks of other countries.
This meant that other countries’ currencies were not backed by anything and governments could print money, however and whenever they wanted. The final link between the dollar and gold broke on August 15, 1971. This paved the way for the great American inflation of the 1970s and early 1980s.
The politics of guns and butter
In the 1960s, the United States had a budget deficit. This was mainly because of the “gun and butter” budgets that were managed by American politicians at the time. The word “weapon” referred to the war the United States was waging in Vietnam, and the word “butter” referred to social programs designed to achieve very low unemployment and income redistribution.
This continued into the 1970s. Breaking the link with gold allowed the US government to flood the world with more and more dollars. This eventually led to high inflation. Of course, what happened in the United States was nothing compared to the German hyperinflation of 1923. Inflation peaked in March 1980 at 14.8%. Although this may not seem as bad as what had happened in Germany, it was nevertheless the highest inflation ever recorded in the United States since the late 1940s.
Paul Volcker took over as chairman of the US Federal Reserve, America’s central bank, in August 1979. Determined to bring down inflation, Volcker began raising interest rates. In May 1981, the federal funds rate, a key short-term interest rate used by the Federal Reserve to conduct its monetary policy, was raised to over 19%.
Inflation under control
As Christopher Leonard writes in The Lords of Easy Money about Volcker: “[He] was prepared to push the unemployment rate to 10% to do so, to force homeowners to take out mortgages carrying interest rates of 17% or more, and to make consumer loans so expensive that many Americans would not could not afford to buy cars. ”
The idea was to make silver more expensive, in hopes of lowering consumer demand. When this happened, less money chased the same set of goods and services, leading to higher prices or lower inflation. This is precisely what happened when inflation fell to around 2.5% in mid-1983.
So, what lesson can we draw from these two inflations? As Milton Friedman wrote in Money Mischief – Episodes in Monetary History: “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and remedy of inflation… Inflation occurs when the quantity of money increases significantly faster than production, and the faster the increase in the quantity of money per unit of production, the higher the rate of inflation. there is probably no other proposition in economics as well established as this.
To put it simply, high inflation occurs when the amount of money chasing the same set of goods and services increases rapidly.
What can we learn from this?
When the Covid-19 pandemic broke out in early 2020, central banks in developed economies started printing money. The idea was to flood the financial system with money and help governments, businesses and individuals borrow at lower interest rates. This would stimulate economic activity and, in doing so, help prevent an economic depression. One estimate suggests that almost $10 trillion worth of money was printed by different central banks.
Much of this money was indirectly given to governments. In turn, governments deposited this money directly into people’s bank accounts. Generous unemployment benefits were also granted in much of the Western world. This sent the demand for things skyrocketing. At the same time, global supply chains have collapsed. The world found itself in a situation where too much money was driving out fewer goods, driving up prices in the process, leading to high inflation.
Meanwhile, central banks in the rich world were caught off guard, mainly because much of the rich world hadn’t seen high inflation for some time. Now they are trying to contain high inflation by raising interest rates and phasing out some of the money they printed and pumped into the financial system.
They realized that the current inflation is a monetary phenomenon. Of course, in the process, they run the risk of driving up interest rates and triggering an economic recession. And that’s the way things are right now.
As the philosopher George Santanya once said, “Those who cannot remember the past are doomed to repeat it.”
Vivek Kaul is the author of the Easy Money trilogy