Venezuela Is Living a Hyperinflation Nightmare

In most macroeconomic models, the economy is a staid and stately thing, where prices, output and other economic variables wiggle up and down by small amounts but ultimately return to their long-term trends. And for much of the time — excluding the occasional Great Depression or Great Recession — developed countries conform to this picture of stability. But in some countries, and in some periods, truly spectacular things happen to an economy. Usually, they are bad things. And the most spectacular, and least understood, is hyperinflation.

Normal inflation and hyperinflation are so different in scope that they might as well be regarded as separate phenomena. Inflation in the U.S. for the past decade has hovered at or less than 2 percent, which is the Federal Reserve’s official target. In 1980, it reached a high of almost 15 percent. But at its peak in 2009, Zimbabwe’s inflation reached 500 billion percent.

Now, Venezuela is the latest country to experience this rare and devastating phenomenon. Data is hard to come by, but some estimates put that country’s inflation rate at more than 4,000 percent.

When More Isn’t Better

Venezuela’s annual inflation rate

Source: Calculations of Steve Hanke, Johns Hopkins University

Moderate inflation rates of 2 percent or even 15 percent are more of a nuisance than a scourge. At the higher end of that range it requires some extra effort to negotiate cost-of-living increases in people’s paychecks, and fluctuations in the inflation rate can generate surprise windfalls for borrowers and lenders. A burst of unexpected inflation can also redistribute income from savers to borrowers, which could either hurt or help the economy, but is likely to hurt older people living on fixed incomes.

But at 4,000 percent, inflation is like a hurricane. Savings are quickly wiped out. Expectations that saving will be fruitless deters people from investing, causing a recession and leading to capital flight. Nobody really knows how much their paycheck will be worth by the time they go to the store to spend it, so the entire labor system is thrown into chaos. Hyperinflation is probably one of a number of reasons why Venezuela, the country with the world’s largest oil reserves, now has starving children.

This means that while normal inflation is only a minor worry for policy makers, great care should be taken to avoid hyperinflation. But it’s hard to avoid something when you don’t know the causes.

To many, it seems obvious that money-printing by central banks is what produces hyperinflation. But even if this is happening, it would be wrong to automatically assume that the former causes the latter. Central banks may simply be accommodating the public’s desire for more currency to spend, as prices spiral upward, in a desperate (but usually doomed) attempt to keep the economy from grinding to a complete halt. Whatever kicks off the hyperinflation might have little to do with the actions of the monetary authority.

Hyperinflations are so rare, and so far outside the bounds of typical macroeconomic models, that it makes sense for economists to use a different approach to study them. The best studies of hyperinflation approach the phenomenon as detectives — examine the specifics of events and policies in each case and try to draw generalizations.

One such effort was made by Thomas Sargent, a Nobel Prize-winning economist now at New York University, in 1981. In “The Ends of Four Big Inflations,” he looked at hyperinflations in Austria, Hungary, Poland and Germany in the 1920s — the latter being the iconic Weimar hyperinflation. His conclusion was that all four episodes resulted not from excessive money printing, but from central banks lending the government money for fiscal purposes:

In each case…once it became widely understood that the government would not rely on the central bank for its finances, the inflation terminated…[I]t was not simply the increasing quantity of [money] that caused the hyperinflation[.]

Sargent’s theory, stated simply, is that hyperinflation happens when people realize that the government is just going to run infinite deficits financed by infinite central bank money-printing.

Sargent’s analysis is limited by the fact that all four of the inflations he studies were the result of war reparations made by the Central Powers in the wake of World War I, so generalizing from them is hard. Other economists have done more recent follow-ups. A 2007 study by the International Monetary Fund’s Sharmini Coorey, Jens R. Clausen, Norbert Funke, Sònia Muñoz, and Bakar Ould-Abdallah found that hyperinflations generally end when the government implements a broad-based package of reforms, including balancing the budget, liberalizing prices and exchange rates, and tightening the money supply.

This is important work. But the countries discussed tend to be small and poor, and to do a lot of their borrowing from outside their borders. The question remains of whether monetary financing of government deficits would be sufficient to cause a hyperinflation in a country where the government mostly owes money to its own citizens.

This is a cricital for rich countries right now. The Republican tax reform bill will probably add a huge amount to the U.S. national debt, and Japan’s debt is even higher. Some economists, whose unorthodox theory goes by the name of modern monetary theory, claim that this is safe, because the U.S. and Japan mostly finance their debts internally. If private banks and citizens won’t buy bonds, the idea goes, the central bank can step in.

According to Sargent, this could easily cause a hyperinflation. MMT proponents also acknowledge the possibility, but think it’s remote. The question of whether government deficits matter, in other words, rests crucially on the still unresolved question of what causes hyperinflation in the first place. Is it an acceleration of money creation by the central bank? Is it the central bank’s decision to fund government spending directly? Is it some combination of external economic shocks?

Economists need to pull out all their detective skills and find the answer. But until the mystery of hyperinflation is more thoroughly investigated, a cautious approach to the deficit seems appropriate.