The Cato Institute’s Steve Hanke has estimated that Ukraine’s inflation rate is now running at 64.5% per month – well above the 50% per month that is usually used as the definition of hyperinflation. If this continues, the political and economic consequences are likely to be horrific.
Worryingly, an analysis of current conditions in Ukraine and a comparison with previous episodes of hyperinflation suggest the country is highly vulnerable to such a scenario.
The hyperinflation process
While the political economy of hyperinflation is often complex (see below), in simple terms it is caused by governments creating large amounts of money. Instead of funding public spending through borrowing from investors or collecting taxes, governments print money or create it electronically.
Expectations then come into play. As governments rapidly debase the currency, individuals lose confidence in the money. More and more people expect its purchasing power to decline. They try to reduce their cash holdings to limit their losses from its depreciation.
Money then becomes like a hot potato. People try to pass it on as quickly as possible. The velocity of money explodes as it circulates far more rapidly through the economy.
There is a ‘flight to real goods’ as money is exchanged for items expected to more reliably hold their value, such as cigarettes and tinned food. This results in what Mises termed a crack-up boom.
Eventually, the transaction costs of using the money rise to such an extent that it is rendered useless and new forms of money, such as gold, foreign currency – or even cigarettes – are used instead, along with barter.
In the meantime, high rates of inflation have made economic calculation almost impossible, and huge malinvestments have taken place. The later stages of hyperinflation and any subsequent stabilisation, are generally marked by a painful adjustment process as these malinvestments are liquidated, and governments slash spending and/or raise taxes.
The Weimar Republic
Only by looking at the detail of particular episodes of hyperinflation does one begin to appreciate its horrors.
The first sign of trouble in Germany was when it went off the gold standard in 1914. The government then borrowed and printed money rather than raising taxes to pay for the war.
By 1917, the amount of money in circulation had risen five fold. The main surge in prices came after the war ended, however. The people had been hoarding cash during the conflict, for security, and because many goods were unavailable.
Then, in 1919, this money came flooding back into the economy – prices rose by around 300% that year.
It was then that people lost confidence in the currency – this mindset not helped by the Treaty of Versailles and the hefty reparation payments imposed on Germany. The flight to real goods began, and the hyperinflationary process accelerated.
There was also a problem for a government committed to maintain, as far as possible, its spending levels, in that high inflation made it in some ways even harder to collect tax to balance the budget. Eventually they ended up adjusting taxes by the month. But another problem was that companies would deal in foreign currencies using foreign bank accounts, to avoid holding Marks, making tax avoidance easy. The increased use of barter also didn’t help the collection process.
Germany also faced enormous instability, and this perhaps partly explains politicians’ unwillingness to exact big public spending cuts and their preference to use the ‘hidden tax’ of inflation to fund expenditure. There were hundreds of political assassinations and both the communists and national socialists threatened the nascent democracy, while the French were trying to break the country up by establishing a Rhenish republic.
Indeed it was after the French invaded the Ruhr in January 1923 – Germany’s industrial heartland – in retaliation to default on war reparations – that inflation accelerated to the level that has become the stuff of legend.
The German government lost a major source of revenue, but insisted on funding the Ruhrkampf, the struggle against the French occupation, and kept paying out dole for unemployed workers in the Ruhr.
Even at the end of 1922, the cost of living had risen by 1500 times since the war, while wages had gone up around 200 times.
But the worst was yet to come. The cost of living index, fixed at 1 in 1914, had risen to an average 15 million by September 1923, 3,657 million in October and 218,000 million in November – when the Mark was finally abandoned.
By this stage, only 1% of the government’s budget was funded from tax receipts, the rest through printing money.
In the last months of the Mark, people would queue outside banks with buckets and wheelbarrows because so much currency was required to buy basic goods. Local authorities and large firms were allowed to issue their own notes in lieu of Marks, to address the shortage. Around 300 factories were employed to print notes.
In the worst period, a cup of coffee that had cost 5000 Marks would cost 8000 Marks by the time it had been drunk. Diners’ restaurant bills would rise as they ate. Newspapers would list new prices for tram and taxi fares every morning.
Thieves would steal baskets and suitcases full of money, but leave the money and keep the containers.
It played hell with economic calculation and many businesses shut down in the last months.
Wider social effects
Another result was widespread famine in the large cities. Malnutrition was endemic and disease rife, particularly TB among children.
Although the harvest had been good, farmers were unwilling to exchange food for worthless currency. So the cities starved and the inhabitants ate rats and dogs to stay alive.
In contrast, farmers were doing rather well. Their fixed rate mortgages had dwindled to nothing. They could barter food for luxury goods from the urban middle classes, so farms would boast cars, expensive jewellery, fine furniture, grand pianos etc.
Of course, the urban middle classes saw their wealth destroyed by the inflation, and ended up selling valuables for essentials. Those relying on savings income were in a particularly poor position, and often ended up in the soup kitchens.
As an aside, it was very difficult to protect one’s wealth. There was a mania to invest in shares, and companies did well initially in the ‘crack-up’ boom, but by 1923 most shares were trading at a tiny fraction of their 1914 values, measured in pounds, and dividends had declined even more. In terms of purchasing power, shareholders were looking at a loss of 90% plus, much better than cash or government bonds, but still an absolute disaster. Rental property was also a disaster since rent controls stopped landlords raising rents in line with inflation. By 1923, foreign students with dollars were able to buy rows of houses in Berlin using their allowances.
Gold and foreign currency were far better inflation hedges, and both were in high demand during the hyperinflation, though even with these you would tend to lose significantly in terms of purchasing basic goods. Possession of such goods, such as coffee, sugar and fuel, not to mention food-producing land, was perhaps the surest insurance policy.
In the initial stages, the working classes did a bit better than the middle classes.
They received more frequent wage increases thanks to the political power of the unions, but eventually they lost out as factories and coal mines closed down, and millions ended up unemployed on a pittance of dole money.
Entrepreneurs, particularly currency speculators often did well, and those who could obtain foreign currency could pick up assets at bargain prices in the later stages of the inflation. There was great resentment at their success, while most people were borderline starving.
Given this boiling cauldron of suffering and resentment, it is unsurprising that there was significant urban unrest. Linz in Austria, which was also affected by hyperinflation, was plundered by a raging mob, with shops looted. They didn’t just steal, they also smashed up fittings and furniture. Food shops were looted in Berlin and there were numerous riots in just about every city in Germany. Parties of workers raided farms, slaughtering animals and tearing the meat from their bones, before torching the buildings.
State of emergency
Predictably all this unrest led to a government crackdown, and in September 1923, seven articles of the constitution were suspended and a state of emergency introduced.
There could now be restrictions on personal liberty, freedom of expression, freedom of the press and freedom of association. The army and the police could interfere at will with postal, telegraph and telephone services, indulge in house searches, and confiscate property.
Incitement to disobedience could be punished with imprisonment or a fine of up to 15,000 gold marks. If lives were endangered the punishment would be penal servitude. Death would be the penalty for the ring-leading of armed mobs, treason, arson or damage to the railways.
The parallels with Ukraine
Unfortunately, these are the kind of developments that could afflict Ukraine if hyperinflation continues to take hold. Worryingly there are striking parallels with the situation in 1920s Germany.
In particular, the Ukrainian government faces an existential crisis combined with a collapse in tax revenues, meaning there are strong incentives for policymakers to attempt to maintain some semblance of political stability by printing money to buy-off various interest groups – in the short term at least.
The strong presence of potentially destabilising far-right groups in both the government and the military is an especially disturbing aspect of the current situation. And as in Germany, there are also some groups that could potentially profit from a hyperinflation episode.
Ukraine’s corrupt oligarchs, several of them holding political office, own vast assets abroad, and, unlike ordinary Ukrainians, are to a large extent insulated from the currency collapse. Along with overseas investors with hard currency, they may find opportunities to buy valuable Ukrainian assets at bargain prices during the crisis. Of course, this assumes that hyperinflation does not result in the nightmare scenario of some form of totalitarian regime coming to power.
Given the obvious risks, it is absolutely vital that the Ukrainian government changes course quickly before hyperinflation becomes entrenched. This perhaps means enacting spending cuts and doing as much as possible to de-escalate the political crisis and restore confidence.
When Money Dies by Adam Fergusson
Human Action by Ludwig von Mises
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