Hyperinflation, a real risk? Images_of_Money

Leafing through most economic dictionaries, one can observe a myriad of definitions put forward to describe inflation. In a less ideologically marked conception, inflation can be defined as an increase in prices in a generalized, cumulative and lasting manner. Therefore, an increase in price is not necessarily inflationary. Inflation increases the cost of living and erodes the purchasing power; nevertheless, if prices for certain products increase with a correspondent improvement in the quality of those products, while leaving the choice up to the consumer, inflation shall neither affect one nor the other.

As for hyperinflation, it stands for a minimum of a double-digit inflation rate, equal to or greater than 10%. It usually entails a severe economic downturn. Phillip Cagan defined it, in 1956, as a period during which the level of inflation remains above 50% every month. By definition, in order to constitute hyperinflation, inflation rates will be unpredictable, uncontrollable and exponential, while exceeding 50% monthly, or the annual threshold of 12,500 %.

This article questions whether hyperinflation may constitute a realistic risk for the European economy and the crisis it is currently facing. Or, on the contrary, whether it can constitute a means towards setting Europe back into a growth path?


Inflation: an entirely negative phenomenon?

When there is an excess of currency, issued by banks, circulating in a given economy, economic agents will tend to spend more. Through an increase in consumption, products will become scarcer. Consequently, prices will have a general tendency to increase, to restore the balance between supply and demand.

But inflation is not an altogether negative phenomenon. Households can consume more in anticipation for a future price increase. And therefore, temporarily, inflation can uplift demand and expand the standard of living of the debtors. When a society is struggling economically, it could be wise to introduce inflation as a mechanism to replenish economic activity. Thus, in the case of the European economic crisis, it would be appropriate to establish strict rules for budgetary control, to allow for investment and growth. In a way, it is necessary to create a sort of European New Deal.

This would inject money into the economy, improve consumption and generate new jobs. However, in the long-term, it would require a return to fiscal stabilization, once the European economy picks up and starts growing again. A case in point is that of the United States of America, with a monetary policy focusing on growth and on promoting long-term fiscal consolidation. It allowed for high inflation rates, only to have them reduced once its economy started to grow.

What is absolutely negative is having an uncontrollable inflation. Indeed, the price component in a market economy is an essential instrument for information transmission; therefore, high inflation decreases the efficiency of the market economy.

These circumstances could be found in Germany, in the aftermath of the First World War. Faced with major war reparations and the occupation of the Ruhr region, the government deficit grew exponentially. Therefore, in order to cover its expenses, the state issued increasingly more currency, leaving the field clear for hyperinflation. In an effort to tackle this problem, Germany cut its spending budget and benefited from the Dawes Plan, through which British and American capital assisted in restocking German reserves.

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In addition to the German case, hyperinflation has sprung out in times of economic crisis, especially during the Second World War and its aftermath (1941-49) and right after the end of the Cold War. In the 1980s, the region of Latin America was particularly affected, with two significant episodes in Chile (1970-73) and Bolivia (1984-85).

In these conditions, entrepreneurs will pay a closer attention to decisions regarding managing their production rather than investment. Some degree of economic planning will be required, in the long-term, and it will impact mostly on the poorest economic agents; it will become increasingly difficult to acquire real assets such as homes, businesses or even actions.

Therefore, while a modest inflation is desirable in times of crisis, it is fundamental not to go overboard and risk the degree of hyperinflation that brings with it devastating socio-economic consequences. Therefore, this begs the question: what degree of inflation would be ideal to bring back growth?

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(Source: "Bill Mitchell - billy blog")


What inflation rate should we have?

In Europe, inflation has been kept under control in some countries of Western Europe for some time. Indeed, France and Germany have been registering annual inflation rates below the 3% threshold over the past twenty years. As a result, economic agents have grown accustomed to controlled low inflation and tend to react negatively whenever it threatens to increase.

This lack of interest in an increasing inflation is partly due to German history, whose hyperinflation experience in the early decades of the XX century remains etched in European collective memory. After that, the Deutsche Bundesbank has focused tremendously on price stability. Therefore, the European Central Bank, as we know it, created in 1999, has followed in the footsteps of the Deutsche Bundesbank and the Euro became the successor of the Deutsche Mark. The German hyperinflation trauma of eighty years echoes in the concerns of the ECB, in its single purpose of maintaining price stability and an inflation rate below 2%.

Nevertheless, we previously demonstrated that higher inflation could engender a short-term increase in demand and thus some degree of economic improvement. As a result, there could be some positive consequences deriving from a decision by the ECB to grant member-states in difficulties, such as Greece or Portugal, easy monetary financing of budget deficits. This funding could take place through the purchase of public debt on the secondary market. A higher inflation rate could be reasonably conceived if these countries were not integrated in the Eurozone, as they would have to seek funding from their own national central banks. Their membership in the Eurozone has automatically excluded this potentially alternative path.

We must add that the cumulative deficits of countries in the group of “PIGS” (Portugal, Ireland, Greece and Spain), in 2009, were the equivalent of 2.14% of GDP in the Eurozone. In other words, even if the ECB decides to assist these governments, the threat of hyperinflation is not in the agenda.

It is therefore perspicuous that alternative opportunities are real and keeping the inflation rate at 2% is wholly fictitious, in the sense that nothing obliges the ECB to maintain this rate. It might be a wise decision from its Governing Council to modify the inflation rate set and allow for some variations in 2% rate. In fact, article 127 of the Treaty of Functioning of the European Union allows for the ECB to support other policies with respect to the objective of price stability.

However, even though the ECB has the ability to do so, it is not likely that member-states will want to align with new policies. Economically speaking, a rise in inflation is not necessarily a negative thing; however, in political terms, the majority of member-states that are to, various degrees, affected by Angela Merkel’s Germany, rejects this idea.

  


References: 

Cagan, Philip (1956). "The Monetary Dynamics of Hyperinflation". In Friedman, Milton (ed.) Studies in the Quantity Theory of Money. Chicago: University of Chicago Press. ISBN 0-226-26406-8.

«Consolidated Version of the Treaty on the Functioning of the European Union». Official Journal of the European Union. 9th May 2008. C 115/47.

Edited by: Margarida Hourmat

Photo Credits: Images_of_Money via Flickr