The dangers of hyperinflation in Ukraine

?????????????????????????????????????????????????????????????????????????????????????????????????????????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.

Urban unrest

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.

Further reading:

When Money Dies by Adam Fergusson

Human Action by Ludwig von Mises

Unless otherwise stated, all articles on this website are written in a personal capacity.


HS2 a classic example of special interests capturing policy

An excerpt from the Treasury Select Committee session on the costs and benefits of HS2, held on 5 November 2013:



The railways are a classic example of a politically distorted market

In September 2012 I was invited to discuss rail policy with the Transport Select Committee. The session can be viewed here (@39 min). Some excerpts from the (uncorrected) transcript are provided below:

Chair: Do you support the Government’s overall strategy in HLOS [the government’s rail plan]? Have they got the right priorities?

Dr Wellings: I would say no. The Government has not dealt with the fundamental problem that the rail industry is hugely distorted by subsidies and other distortions such as the planning system. Basically, the central planners in the DfT are groping about in the dark. They don’t have an idea of genuine levels of demand or genuine prices because we also have price controls. Before embarking on these absolutely huge investments at taxpayers’ expense, they ought to get the fundamentals right and remove these distortions and, in particular, the subsidy regime.

Chair: What would you like to see change?

Dr Wellings: I would like to see the subsidies phased out and a change in the planning laws that force developers into corridors around railway stations, for example. There needs to be a change in the tax regime as well so that there is a level playing field with other transport modes.

Mr Leech: Dr Wellings, you argue that there is no economic case for the improvements because of the cost to the taxpayer. You suggest that taxpayers are already paying about £5 billion a year in subsidy. As far as you are concerned, that is an unacceptable level of subsidy. What would be an acceptable level of subsidy?

Dr Wellings: Zero. I would like to see it phased out over a period of, say, 10 years to zero.

Mr Leech: What impact do you think that would have on fare prices on trains and the number of passengers who could afford to use them?

Dr Wellings: It would vary. I don’t think it would have much impact on, say, the London commuter market, which I think is probably fundamentally economically viable, particularly if we also liberalise the planning system so that rail companies could make money from property development as they do in Japan. At the other extreme, you have railways in places like rural Wales that are very poorly used. I think they should definitely close down. There is no economic case whatsoever to keep them going and there is also no social case.

Mr Leech: On the basis that there is a subsidy taking people out of cars and reducing carbon emissions, in your studies what impact would there be on carbon emissions and on the cost to congestion as far as the economy is concerned? Have you done any of that work?

Dr Wellings: It is a myth about carbon emissions. If you closed the entire rail network down overnight, the impact on carbon emissions would be barely measurable. There are two reasons for that. One is that it is quite a small share of overall transport use. The second reason, of course, is that we are talking about a different market from cars. A high proportion of journeys are into central London, for example. These would probably hypothetically go on to coaches and buses, which are more efficient than trains. It would actually be barely measurable.

There is also the effect of subsidising people to move further and further away from where they work through cheaper train fares. You end up, for example, with long-distance commuters through the season ticket system. Although the rail journey might be relatively efficient from an environmental perspective, in terms of the whole lifestyle they probably emit more than if they lived in inner London or close to work.

Steve Baker: Dr Wellings, in your article for City AM in July you were highly critical of the Government. You said that “cynical political calculation seems to be the driving force of policy”. You talked about the railways as a classic example of a politically distorted market. You have also said, without reading the whole article, that many of the projects are motivated by politics rather than economics. Could you give us some examples of where these things can be seen?

Dr Wellings: Yes. The most telling example from the recent plans was the plan to electrify the branch lines in south Wales. Of course the Welsh railways already have perhaps the highest operating subsidies per passenger mile in the whole network. We already have a false market, a rigged market, and yet we are going to invest good money after bad in this already hugely subsidised market. It seemed that the Government was allocating new schemes across the country to pay off various special interests. Few of them made any economic sense. For example, if you wanted a fast train up to Sheffield, it can already be done by the East Coast Main Line in an hour and three quarters. There just isn’t the demand for that kind of service. The idea to spend this money electrifying the Midland Mainline to make some very tiny time savings didn’t make any business sense to me.

Of course the worst example of all is High Speed 2, which has a very low benefit-cost ratio. We saw road schemes being cancelled in the Comprehensive Spending Review that had a benefit-cost ratio over three times High Speed 2. There is no economic logic at all behind current transport policies.

Chair: We are on rail today, though.

Steve Baker: I would follow it up by asking this question. Isn’t it true that all Government investment decisions, including right across transport, are influenced by politics to some degree?

Dr Wellings: What we have is basically a thinly veiled version of Soviet-style central planning here. It is hugely centralised with the DfT and politicians making the big decisions. This is in a morass of economic distortions from price controls, subsidies and distortionary tax treatments as well. These people just can’t make sensible investment decisions because, first, it is hugely politicised, and, secondly, because we don’t have genuine prices or genuine levels of demand.

The deeper causes of Britain’s economic stagnation

Mancur Olson is best known for his 1965 book, The Logic of Collective Action, in which he explained why small, concentrated interest groups are more likely to influence policy than large, dispersed groups. Olson’s work, together with that of other public choice theorists, exposed the mechanisms by which interest groups obtain special privileges from government, enabling them to extract ‘rent’ from the wider population. For example, a domestic industry might lobby politicians to introduce import tariffs or environmental regulations to shut out foreign competition. In The Rise and Decline of Nations (1982), Olson contended that over time, concentrated interest groups – facing little public resistance – would come to dominate more and more sectors of the economy, stifling competition and innovation, misallocating resources, crowding out entrepreneurial activity and thereby bringing economic stagnation.

In the recent debate over Britain’s poor economic performance, there has been relatively little discussion of the underlying causes. Olson’s analysis provides a compelling explanation for many of the long-term structural problems now afflicting the UK economy. Much economic activity is now artificial in the sense that it is not the result of voluntary exchange but rather the consequence of state-granted privileges resulting in part from ‘rent-seeking’ behaviour by special interests.

Whole swathes of the nominally private sector are sustained by government regulation rather than consumer choice. Across the professions, occupational licensing restricts entry and raises fees, while at the same time, regulations create artificial markets for professional expertise. Complex tax rules create work for accountants and tax lawyers, for example. Vast industries such as renewable energy and waste recycling have been brought into being by combinations of regulation and subsidies. And major sectors of the economy are now heavily dependent on special privileges granted by the state at the expense of the wider population. Agriculture, energy and public transport are three obvious examples, but a strong case could also be made for numerous sectors including banking (bailouts, QE, etc.), pharmaceuticals (licensing etc.) and vehicle manufacturing (non-tariff barriers etc.). In this context, the success or failure of businesses is frequently dependent on political favours rather than satisfying customers’ preferences. Given such incentives, devoting resources to rent-seeking behaviour is entirely rational, even if it is at the expense of consumers and taxpayers and the health of the wider economy.

Clearly cutting public spending is an important part of reducing the pernicious influence of special interests. It will tend to reduce the share of the ‘private’ sector reliant on government subsidies. But there is little sign that the coalition understands the economic importance of dismantling the web of regulatory privileges enjoyed by concentrated interest groups. Indeed, several government policies have actually increased opportunities for rent-seeking.

Olson was generally pessimistic about the prospects for fundamental reform in stable Western societies. Only extreme events such as wars and revolutions were likely to break the hold of powerful interest groups over policy and restore economic dynamism (arguably West Germany after World War 2 is an example of this). Yet the success of Margaret Thatcher in tackling the unions suggests that it can be done. A similar strategy against ‘middle-class’ professions would be a good starting point.

For an illustrative case study of special-interest influence over policy, and its harmful economic effects, see The High-Speed Gravy Train: Special Interests, Transport Policy and Government Spending.

26 April 2012, IEA Blog

Infrastructure stimulus will be counterproductive

As the economic slump persists, calls are growing for an increase in infrastructure spending as a means of boosting growth. Both David Cameron and Nick Clegg have announced plans for the delivery of planned schemes to be speeded up in order to bring forward the alleged benefits.

In theory, investment in infrastructure has tremendous potential to promote recovery. Improved transport links can reduce journey times and deliver significant productivity gains. Businesses can pass on their savings to customers in the form of lower prices, which in turn boost demand for their products and services. Transport investment can also increase productivity by lowering the costs of trade, which in turn promotes competition and specialisation, as well as facilitating greater economies of scale.

Energy investment can be similarly beneficial. Lower energy bills reduce business costs and increase productivity by enabling greater use of labour-saving technology. The released labour can then be put to other productive uses.

The policy of increasing infrastructure spending during a slowdown is therefore very appealing; however, there is one major problem: politics.

Politicians and senior government officials have very poor incentives to invest efficiently. Instead, they are likely to allocate resources in order to boost their own positions. Politicians may seek to satisfy special interest groups and increase their chances of re-election; senior officials may seek to enhance their power and status by consolidating their department’s influence over policy. In addition, ideological considerations – such as a focus on ‘fairness’ or the environment – may trump economics when it comes to investment decisions.

A further problem is the loading of financial risks onto taxpayers. Politicians and bureaucrats may be less concerned than private investors about making bad investments that lead to huge losses.

The history of infrastructure spending bears out these concerns. A high proportion of investment has been directed towards loss-making projects that have failed to make anything close to a commercial return. Worse still, many schemes have required ongoing operating subsidies to keep them going. Capital expenditure has been written off.

Recent examples of loss-making projects include the tram schemes constructed in several major UK cities over the last two decades, the Channel Tunnel Rail Link (High Speed 1) and the upgrade of the West Coast Main Line. In today’s money, the total cost of these schemes is in the order of £25bn.

Part of the problem is that politicians seem to favour high status ‘big projects’ over smaller schemes that offer much better value for money for taxpayers. The government is now supporting big and expensive rail projects, such as Crossrail (£17bn) and High Speed 2 (HS2, £34bn). Both of these schemes are likely to be loss-making. Taxpayers, not commercial investors, are funding their construction. Realistic projections of passenger numbers also suggest that fares will struggle to cover operating costs, meaning taxpayers will face an ongoing subsidy burden for decades to come.

It is important to point out that such investment decisions are essentially political in nature. According to the government’s own cost-benefit analyses, there are a very large number of transport schemes with far higher returns than Crossrail and HS2. Some, such as the Heathrow expansion, would have been entirely privately funded. Yet most of these initiatives will never be undertaken. Scarce resources will instead be devoted to wasteful high-profile vanity projects.

However, there is an argument that when it comes to promoting recovery, long-term returns are perhaps less important than boosting short-term demand in the economy. Keynesian economists argue that increasing public spending can create a positive multiplier by utilising idle resources. For example, if unemployed people are given jobs, they then have more money to spend on goods and services.

There are, however, several reasons why stimulus policies are unlikely to succeed in achieving a sustainable recovery.

Firstly, public spending absorbs resources that would otherwise be available to the private sector – a process known as ‘crowding out’. Private sector investment will tend to decline as the role of the government expands.

Secondly, stimulus policies inevitably involve higher levels of government borrowing. Increased public debt puts upward pressure on interest rates, raising the cost of loans for private investment. It also raises expectations that taxes will rise in the future to pay off the debt, which in turn reduces investors’ confidence in the long-run performance of the economy.

Finally, public spending creates vested interests that depend on continued government support. After the recession is over, it becomes difficult for politicians to withdraw subsidies for activities initiated during the stimulus programme. The role of the state may increase permanently as a result of policies undertaken during slumps, with highly negative long-term economic effects resulting from a higher tax burden and less economic freedom.

Historical evidence appears to support critics of stimulus policies. For example, many commentators now view Roosevelt’s New Deal as a failure in terms of promoting recovery from the Great Depression. Wasteful spending on new roads, dams and irrigation projects arguably ‘crowded out’ private sector investment on more productive enterprises. Indeed, the US went back into recession in the late 1930s – in 1938, for example, living standards were lower than they had been 15 years earlier in 1923.

More recently, infrastructure spending spearheaded efforts by the Japanese government to lift the country out of prolonged stagnation. Once again, the economic record suggests that this was unsuccessful. Worse still, the ill-fated stimulus programme has left Japan with a national debt at over 200% of GDP – higher than Greece and Italy.

So even if stimulus spending were somehow allocated efficiently, there would still be major downsides. In reality, there is little reason to expect that the UK government will invest any more successfully than other governments. Indeed, recent evidence suggests that infrastructure investment will be wasteful, politically driven and will incur losses that burden taxpayers for decades to come.

19 December 2012, PPPJ

Politicians should get out of the transport market – starting with High Speed 2

Britain’s transport sector is cursed by endless intervention by politicians. Investment has tended to be driven by political priorities rather than consumer demand. The emphasis has been on satisfying concentrated special interests rather than the wider populations of taxpayers and transport users. The latest example is High Speed 2 (HS2) – critiqued in a new IEA paper released today.

HS2 exemplifies the government’s flawed approach to transport policy. It is a centrally-planned, highly political project with all the deficiencies that implies. In particular, central planners struggle to allocate resources efficiently because they cannot access the dispersed and subjective information held by individuals. This problem is exacerbated on the railways since policymakers are operating in the absence of genuine market prices. Indeed, a wide range of economic distortions, including price controls, large state subsidies and an artificial industry structure, make it very difficult to make efficient investment decisions.

The incentive structures facing politicians and transport planners also lead to the misallocation of resources. Financial risks are offloaded on to taxpayers, often many years in the future, while in the short-term politicians and senior civil servants can gain prestige from their ‘grand designs’.

Accordingly, it is unsurprising that the government’s economic case for HS2 is deeply flawed. The passenger and revenue projections are hugely optimistic compared with other, independent,estimates. There are also several unrealistic assumptions – perhaps the most ridiculous is that business people can’t do any productive work on trains. It is also clear that the route of HS2 has been ‘gold-plated’ with little regard to the costs imposed on taxpayers and property-owners: it will be hugely expensive to tunnel the line to Euston and the implications for overcrowding on London Underground may lead to billions more in infrastructure expenditure (funded largely, once again, by taxpayers rather than passengers).

An alternative to the politicisation of the transport sector is provided in Chapter 10 of Sharper Axes, Lower Taxes. Clearly cancelling big, uneconomic projects such as HS2 is a first step. But reform must go much further. Genuine privatisation is needed, not just on the railways but also on the roads. This means more than transferring nominal ownership. Subsidies to public transport should also be phased out, the tax treatment of different modes should be harmonised and the sector should be deregulated. The chapter identifies £15 billion of annual savings to taxpayers in 2015 from such a policy, plus considerable privatisation receipts that could be used to cut fuel taxes. Getting the government out of transport will also ensure that investment serves the needs of consumers rather than inflating the egos of politicians.

19 July 2011, IEA Blog

Is it worth voting?

With the opinion polls pointing to a close result and the prospect of a hung parliament, turnout is expected to be relatively high in today’s election. Yet for economists this presents a bit of a puzzle.

Given that the chance of any single vote being decisive is so small, particularly outside a handful of highly marginal seats, the individual act of voting is arguably irrational – especially since costs are incurred, such as time and effort wasted on the trip to the polling station.

Moreover, one can only vote for a crude package of proposals, which in practice is likely to be changed significantly when it comes to implementation. The political process is extremely inefficient at responding to individual preferences compared with the fine differentiation of markets.

Worse still, various authors from the rational choice school (for example, Olson and Stigler) have shown that policy tends to be determined by special interests rather than the preferences of voters. The “logic of collective action” means that small concentrated groups have a far stronger incentive to commit resources to lobbying politicians and bureaucrats than large dispersed groups such as general taxpayers.

Special interests also engage in “agenda manipulation” to frame policy debates in particular ways and exclude perspectives that are detrimental to their cause. Indeed, Schumpeter went as far as to suggest that politicians and interest groups “are able to fashion and, within very wide limits, even to create the will of the people.” While this may be going too far, a strong case can certainly be made that such strategies further undermine the notion that voting “makes a difference.” (And in some cases, elite interests may simply ignore the wishes of voters, as with the ratification of the Lisbon Treaty).

So why do people continue to vote in large numbers? One hypothesis is that voters find it difficult to calculate probabilities and therefore don’t realise their individual vote is unlikely to make any difference. Another idea is that people vote because they value the preservation of the wider democratic process – they act out of duty and/or altruism. Neither explanation is very satisfactory from a rational choice perspective.

6 May 2010, IEA Blog