What is hyperinflation and where does it come from?
Hyperinflation has a long history, but no official definition. In an influential 1956 paper, Phillip Cagan suggested limiting the term to a rate of inflation of 50 percent per month or more, which is equivalent to an annual compound rate of about 14,000 percent. That would fit extreme cases like Weimar Germany, Hungary after World War II, or, more recently, Zimbabwe, in which inflation rates reached millions or trillions of percent per year.
Although some economists still adhere to Cagan’s guideline, others prefer a more flexible definition. I like to apply the term hyperinflation to any case in which inflation seriously undermines the ability of money to serve its classic functions as a store of value, a unit of account, and a medium of exchange. That can begin to happen at rates of inflation of 100 percent per year or even less. Less extreme cases like Russia, Argentina, and Bulgaria in the 1990s would qualify, even though inflation reached only the low thousands of percent per year. Venezuela may well be approaching such an episode now.
So where does hyperinflation come from? The popular explanation of “too much money chasing too few goods” has an element of truth to it. Still, it is seriously incomplete because it ignores the other elements of the equation of exchange, MV=PQ. In that equation, M stands for the quantity of money, V for velocity, P for the price level, and Q for the level of real GDP.
Velocity is the least familiar term. Intuitively, we can think of it as the rate at which the stock of money circulates through the economy, but formally, it is more accurately defined as the ratio of nominal GDP (that is, P times Q) divided by the money stock, M. We can define money itself more or less broadly (M1, M2, and so on), but for purposes of understanding hyperinflation, it is probably best to use the narrowest definition, the monetary base, consisting of currency in circulation plus bank reserves.
Defining velocity as the ratio of nominal GDP to the money stock makes it clear that the equation of exchange is a simple accounting identity that has no inherent causal interpretation. If we rewrite the equation of exchange in the form P=MV/Q, we can see that an increase in the price level can, by definition, arise either from an increase in the money stock, an increase in velocity, a decrease in real GDP, or some combination of those factors. I like to call this version of the equation of exchange the inflation accounting equation.
The inflation accounting equation holds for any rate of inflation, positive or negative. Hyperinflation is more than just very rapid inflation, however. What gives hyperinflation a distinctive character is the existence of three feedback pathways that link the variable P, on the left-hand side of the equation, and the variables M, V, and Q on the right-hand side. The feedbacks mean that not only does the rate of inflation depend on the rate of change of M, V, and Q, but that the rates of change of those three variables themselves depend on the rate of inflation. Let’s look at each of the pathways in turn.
Feedback via velocity
The first feedback pathway, the one that acts through velocity, arises from the function of money as a temporary store of value. If you get your pay on the first Friday of each month, you can put some cash in your pocket and spend the money on gas and groceries at any time during the month as you see fit. Hyperinflation undermines the store of value function because it causes money to lose a noticeable amount of purchasing power over even a few days. During a period of hyperinflation, instead of putting your pay in your pocket, it is best to run out and spend it quickly before prices go up. The velocity at which money moves through the economy increases accordingly.
Economists call this behavior asset substitution. You stop using currency or bank balances as a safe temporary store of value and instead, exchange it as quickly as you can for some other asset that will hold its value.
Basic consumer goods are one alternative. I remember seeing a good example when I was living in Russia during that country’s hyperinflation of 1992. One day, an economist I was visiting pointed to a neighbor’s balcony, where we could see a pile of several cases of a popular kind of canned beef called tushonka. “That’s hyperinflation at work,” my colleague said. The neighbor, I could see, was no fool to recognize that tushonka–compact, durable, and hard to counterfeit—was a much better store of value than the rapidly depreciating Russian ruble.
Once people have stocked up on consumer goods to the limit of their storage space, asset substitution turns to foreign currency. People exchange their rubles, bolivars, or whatever for dollars or euros as fast as they can . That happened in Russia in the 1990s and it is reportedly happening in Venezuela today, to the extent there are any dollars or euros that people can get their hands on.
The government can slow asset substitution by imposing consumer price controls and foreign exchange controls, and the Venezuelan government uses both. However, doing so has drawbacks. First, such controls tend to be leaky; people find a way to accumulate goods and foreign currency anyway. Second, the controls increase the cost of doing business and slow growth of the economy (more on this below). Third, even if controls are initially effective, they create repressed inflation, which will break out even more virulently when controls are withdrawn or spontaneously collapse. That is exactly what happened in Russia. During Mikhail Gorbachev’s perestroika, up to the end of 1991, price controls held measured inflation to single digits, but at the cost of ever-growing repressed inflation. When the controls were lifted at the beginning of 1992, inflation jumped to a rate of more than 2,000 percent per year in a matter of days.
Other than spying on people’s balconies, how can we tell whether asset substitution is causing velocity to increase? The inflation accounting equation, P = MV/Q, provides the answer. At present, Q, or real GDP, is near a standstill in Venezuela, so it contributes little to inflation one way or another. Holding Q constant, any increase in velocity will reveal itself as a rate of inflation that exceeds the rate of growth of the money stock. That is just the case in Venezuela. According to the latest data, the money stock is growing at about 3 percent per month, equivalent to a compounded rate of about 40 percent per year. Meanwhile, as noted above, the price level is increasing by about 100 percent per year. An increase in velocity accounts for the difference. What we see, then, is a feedback loop in which higher velocity causes higher inflation, and accelerating inflation, in turn, induces asset substitution that causes velocity to increase still more.
Feedback via real GDP
The second feedback pathway that fuels hyperinflation operates through the effect of inflation on the growth of real output. The relationship differs from that implied by the familiar Phillips Curve, according to which higher inflation is associated with lower unemployment, which in turn, other things being equal, would be associated with faster growth. However, the inflation-growth relationship implied by the Phillips curve is applicable only to relatively moderate rates of inflation. As suggested by the following chart, based on data from an IMF study by Atish Gosh and Steven Phillips, inflation in the double-digit range tends to be associated with slower, not faster, growth of real GDP. Inflation of 100 percent per year or more tends to be associated with negative GDP growth.
The 100-percent threshold in this chart is just a statistical relationship, not to be taken as an economic law. Still, the underlying idea that hyperinflation disrupts the real economy is not hard to understand. High inflation makes business planning difficult, especially since inflation is usually variable and unpredictable when it is high. Hyperinflation disrupts financial intermediation, as banks become reluctant to lend for more than very short periods. It disrupts the payments system because it strengthens incentives to pay late. It leads to labor strife, social disruption, and political instability. All of the above promote capital flight. If the government uses price controls and currency controls to combat inflation, those measures further disrupt normal market processes.
Venezuela may be showing the first signs of a feedback from higher inflation to slower growth. Official data indicate that the economy grew at an annual rate of just 0.7 percent in the first quarter of 2013, down from nearly 6 percent in 2012. Since the rate of economic growth, Q, appears in the denominator on the right-hand side of the inflation accounting equation, any slowdown in growth, or negative growth, causes inflation to accelerate, thus completing the second feedback pathway.
Feedback via money
The third feedback mechanism operates through the effect of inflation on the rate of growth of the money stock. The mechanism is less direct than that for velocity or GDP growth, but under conditions of hyperinflation, it can be quite powerful.
The first link in this third feedback pathway arises from the effect of inflation on real tax revenue. No government has yet figured out a way to collect taxes instantly. The tax revenues a government receives are always based on economic activity (income, retail sales, property values or whatever) in some previous period. If there is no inflation, the delay in receiving tax revenue does not affect its real value. However, when there is inflation, the real purchasing power of the tax revenue falls between the base period for which taxes are calculated and the time the government receives the tax payments. If expenditures are constant in real terms, the reduction in the real value of revenues means a larger budget deficit. Economists call the tendency of inflation to increase the real budget deficit the Olivera-Tanzi effect.
The next link is the effect of an increased budget deficit on the money stock. When governments spend money on current purchases or transfer payments, the money stock increases, but that increase is usually offset by reductions of the money stock that take place when the government collects taxes or sells securities. During hyperinflation, however, the offsets do not work as well. The Olivera-Tanzi effect, as we have seen, tends to reduce the real value of tax revenues as inflation accelerates. Furthermore, as moderate inflation shades into hyperinflation, governments find it harder to borrow by selling securities. In extreme cases (say, war or revolution), the government may not be able to sell securities at all so that the increase in the money stock in any period and the budget deficit are equal.
The final link in the feedback pathway is the effect of an increase in the money stock on the price level. As proponents of modern monetary theory like to point out, the inflation accounting equation, P=MV/Q does not imply a one-to-one causal relationship between the rate of money growth and the rate of inflation. The recent experience of the United States provides a case in point. When inflation is moderate and when the economy is operating below full employment, a budget deficit is not necessarily inflationary even if it is fully “monetized,” that is, if the monetary base is allowed to increase by the full amount of the deficit. Instead, the impact of the increase in the money stock may be absorbed, at least in part, by faster growth of real GDP induced by the Keynesian multiplier effect of the higher deficit. A further part of the impact may be absorbed by a decrease in velocity, if people accumulate money balances without spending them.
However, as the rate of inflation accelerates, we can no longer count on falling velocity and rising GDP growth to absorb the impact of faster money growth. Instead, when true hyperinflation sets in, we are more likely to see rising velocity and falling real GDP. In that case, all the links in this feedback pathway come into play: Faster inflation increases the budget deficit via the Olivera-Tanzi effect. The larger deficit is monetized because inflation makes it harder for the government to sell bonds. And faster money growth feeds back to more inflation, because changes in velocity and real output exacerbate the impact on the price level instead of offsetting it.
To be certain that all of this is happening today in Venezuela would require better data and more thorough analysis than are possible here. However, the fragmentary data we do have seem consistent with this scenario. Inflation, as we have seen, is increasing. So is the rate of growth of the money stock. And so is the budget deficit. As reported by Trading Economics, the Venezuelan budget deficit was 8.5 percent of GDP in 2012, up from 5.3 percent the year before. Other sources put the deficit as high as 17 percent of GDP as of early 2013.
What lies ahead?
It is too early to call Venezuela a truly hyperinflationary economy, but it looks to be on the brink. We can see early signs of all of the feedback pathways that make hyperinflation potentially so explosive. It is true that something could yet defuse the process. For example, a sharp increase in global oil prices could provide an unexpected increase in revenue for the budget. Alternatively, although it seems unlikely, the government of Nicolas Maduro could turn away from the populist policies of Hugo Chavez and impose stringent austerity measures. Doing so would be hard on the real economy, but it could bring inflation down.
It is more likely, however, that the Venezuelan government will continue its dysfunctional blend of free spending, socialist mismanagement, and administrative restrictions on foreign exchange and retail prices. If so, the near future could see the first real outbreak of hyperinflation in Latin America since the 1980s. As blogger Billy Mitchell once wrote in reference to hyperinflation in Zimbabwe, “Bad Governments will wreck any economy if they want to.”