The dynamics of hyperinflation
defining hyperinflation and the necessary pre-conditions for hyperinflation
So what exactly is hyperinflation? A common definition of hyperinflation is just “very high” inflation, very high being defined as above 50% inflation per month. Apart from this threshold's arbitrariness, this does not explain the dynamics of hyperinflation.
During hyperinflation, high inflation feeds upon itself in an accelerating positive feedback loop until the currency becomes practically worthless within a short period of time. But what triggers this positive feedback loop of doom? Before I answer this question, let me lay out what is not sufficient to trigger hyperinflation:
Large fiscal deficits, even if monetised, are not sufficient to trigger hyperinflation. Deficit spending can certainly cause high inflation, but something else needs to occur to trigger hyperinflation.
A fall in demand for the currency via depositors minimising their cash holdings is not sufficient for hyperinflation. Again this is a common occurrence in the early stages of emerging market economic crises or social collapse. It is both a cause and consequence of high inflation or a falling currency but cannot trigger hyperinflation by itself.
What transforms merely high inflation into hyperinflation is an artificially low real interest rate at which both the private sector and/or the government can borrow from the central bank. Let me give a few examples to illustrate this phenomenon.
Inflation and Hyperinflation after the collapse of the Soviet Union
Even before the collapse of the Soviet Union, inflation had increased sharply due to a combination of high deficits and sharp increases in wages. The decision to reduce food subsidies in state shops further increased inflation. This culminated in an increase in prices by 250% in January 1992 alone when prices were deregulated. But even in such a chaotic environment, it is difficult to explain how these factors alone could lead to an inflation rate of 2500% in 1992 and 800% in 1993. What led to this almost complete collapse of the ruble was the issuance of new credit at interest rates that were so far below the prevailing interest rate that these loans were simply gifts. The issuance of new credit took place via two channels:
The first was the rampant issuance of ruble credit by the other republics' central banks, which were foolishly allowed to remain in the “ruble zone”. As Stephen Kotkin puts it in ‘Armageddon Averted’:
the Soviet State Bank was replaced by fifteen republic Central Banks, but the currency—the ruble—was retained, under the mistaken view among some Russian officials and the IMF that a single “ruble zone” would promote economic reintegration. Only Russia’s Central Bank, having inherited all Soviet printing presses, could issue paper rubles, but, crazily, all republic banks could issue credits in rubles. “In effect,” wrote one journalist for Rolling Stone, “Russia had fourteen ex-wives, each with a duplicate of the Kremlin Visa card.”
The second was the equally rampant issuance of cheap credit to Russian enterprises, many of whom had their own banks and could award themselves free money. Deficit monetisation was much less of a factor by 1992, and it was this issuance of “free” private credit that was the primary driver of the 1992-93 hyperinflation. Juliet Ellen Johnson has laid out the economics of this free lunch:
With approximately a 50% interest rate per year and a 20-30% per month inflation during 1992, it did not take a very astute enterprise manager to see that borrowing money was intrinsically profitable.
Anders Aslund describes the inevitable result of this process during Viktor Gerashchenko’s time as the head of the central bank:
The Central Bank of Russia issued new credit equivalent to 31.6 percent GDP in 1992. As these loans were largely given at an interest rate of 10 to 25 percent a year, while inflation that year was 2,500 percent, they were sheer gifts. These gifts rendered Gerashchenko very popular among the Russian elite, although the banking sector was rampant with crime thanks to his largesse.
The same process has occurred in many other hyperinflations through history. For example:
Until late in the Weimar inflation, the Reichsbank kept discount rates as low as 5%, a free lunch taken full advantage of by bankers and industrialists to lever up and invest in any real assets they could find. As Adam Fergusson notes, “new borrowings from the Reichsbank…from whom commercial enterprises could obtain credit at very low discount rates even at the height of the crisis in 1923, were automatically written off” due to the ludicrously negative levels of real interest rates that the Reichsbank enabled.
The same was true in Zimbabwe where the central bank not only maintained one-year treasury bill rates at a level well below the inflation rate (enabling monetisation of deficits at a subsidised rate) but did the same with prime and bank lending rates which led to a predictable explosion in private sector credit expansion (see data here for a sample month).
Budget deficits alone do not cause out-of-control inflation as long as the central bank does not finance the government at interest rates far below inflation.
Even if the central bank succumbs to political pressure and finances the government at artificially low interest rates, it is the central bank’s willingness to finance the private sector at similarly low rates that ultimately causes hyperinflation.
Seen through this lens, hyperinflation is a targeted theft of real assets by the well-connected, the rich and the elite who have access to “free” credit.