When money burns in your hands: this is how hyperinflation is created

BarcelonaSince the end of the pandemic, and following the Russian invasion of Ukraine, inflation has returned to the lives of citizens after almost two decades without much talk. In Catalonia, inflation, or the rate of growth in the prices of consumer goods and services, rose suddenly, especially in 2021 and 2022, but moderated again from 2023 onwards. Despite the inflationary moderation, governments, central banks and economic agents sounded the alarm about a possible inflationary spiral.

Hyperinflation is an uncontrolled inflation, in which prices grow to such an extent that the country's monetary authorities can no longer control them no matter what they do. From a purely technical point of view, most economists currently consider that we can speak of hyperinflation when prices grow by 50% monthly, which puts the annual rate above 8,500%. Anything below these figures is treated as very high, but not uncontrolled, inflation.

In other words, when in the summer of 2022 some economists were talking about the risk of hyperinflation when prices in Spain grew at an annual rate of just over 10%, they were completely missing the truth if the technical definition of inflation is taken into account. Even in the most extreme cases of the last inflationary episode in Europe, such as Estonia, where inflation was above 20% for quite a few months, they were far from reaching the 8,500% that economists are pointing out.

In more colloquial language – also among economists – hyperinflation is used in cases of continuous price increases that clearly make life difficult for citizens, quickly erode salaries and savings and cause governments to have trouble stopping them in the short term, but can still be controlled. For example, the World Economic Forum defines it as "incredibly rapid inflation", while Ernest Pons, professor of economics at the University of Barcelona, ​​​​defines it as a situation in which a state "loses control" of the value of its currency and "money burns in the hands" of consumers because it loses value very quickly.

Currently, Argentina and Turkey are the countries where prices are growing the most. In 2023, prices in Argentina grew by 211%, while Turkey has been experiencing rates of between 40% and 70% for several years. "It is difficult to talk about hyperinflation, because it does not give the impression that they cannot be controlled," Pons says about these two countries.

The causes of inflation like that of Argentina or Turkey can be "very diverse," says Pons, but they can be summarized in three. The first cause is an excessively high external deficit that collapses the currency. Taking the recent example of Argentina, it is explained as follows: the drought and the pandemic collapsed Argentine exports of cereals and oil. Therefore, the demand for the Argentine peso in the foreign exchange markets also fell and, by extension, the exchange rate. This had two effects: on the one hand, the lack of exports started an economic crisis (the export sectors have less business) and, on the other, the depreciation of the currency made imports more expensive. Therefore, the price of all products manufactured in other countries, which in the case of Argentina are the majority, began to skyrocket.

The second cause can be too much government borrowing in foreign currencies. As in Argentina, where the government has a significant debt in foreign currency (usually in US dollars), the cost of repaying this debt rises because it needs more pesos to obtain dollars. This forces the government to raise taxes, which can have an even more inflationary effect if taxes on consumer goods, such as VAT, are increased. This situation also occurs in Turkey, where a mix of foreign debt and falling international trade has caused the lira, the national currency, to plummet, making imports into the country more expensive and pushing prices up.

The third is when a government or central bank decides to create money without control, for example to pay its debt. This was the case in Germany in 1923, surely the best-known episode of hyperinflation in Europe. "Governments now know that they cannot create money" without any limitation, Pons recalls.

The German case

In the case of Germany in 1923, the root of the problem lies in the reparations imposed on the German government by the countries that won the First World War, which had ended in 1918. Faced with the need to pay these reparations in kind, Berlin began to buy gold, paying a higher price on the German markets than it was actually going for. When it ran out of gold, it did the same with the currencies of the countries it had to pay. "This is inflationary," says Albert Carreras, professor of economic history at UPF, because it reduces the value of the mark in relation to gold or other currencies.

In addition, when Germany fell behind in paying reparations, France and Belgium occupied the Ruhr region, where much of Germany's coal was produced, in January 1923 in order to seize it and thus compensate for the late payment. The German miners responded by going on strike, and the German government by printing money to pay the miners' wages.

In addition, in the 1920s the US imposed tariffs and restricted immigration, which had an impact on Europe and Germany in particular, as international trade fell, which also has an upward effect on prices. Finally, with all this, the German economy "short-circuited" and inflation soared to unthinkable levels of 1,020,000,000,000% (1.02 trillion percent). The currency was so devalued that banknotes of five, fifty and one hundred billion marks were printed, to the point where, for practical purposes, money was only worth the paper it was printed on and children used them as toys. The situation was so extreme that citizens literally ran to the shops because the currency lost value in a matter of minutes.

The end of the printing of more marks and the Dawes Plan (agreed by the Allies and Berlin) made it possible to stabilise the currency and prices again in 1924.

Hyperinflation is often cited as one of the main causes of the rise of Nazism,193, ten years after the inflationary peak. But the effects were very profound because –Carreras recalls– "they impoverished everyone, but above all the middle classes", who lost their savings and were the great electoral base of Adolf Hitler, who knew how to exploit their indignation.

Impact to this day

The impact of those episodes on the character of German society and on the economic policies advocated by the country's business establishment is still deeply felt today. Germany is the country most opposed to any monetary policy in the Keynesian tradition – especially by central banks – with arguments based on a fear of inflation that sometimes goes beyond rationality. For example, in 2011, when the European economy was barely emerging from a severe recession caused by the financial crash of 2008, the European Central Bank (ECB) raised interest rates twice to curb a slight rise in inflation caused mainly by the rise in oil prices following the Prime Minister's revolts. Both increases, driven above all by pressure from the German Bundesbank and other countries in the centre of the Eurozone, caused the EU to fall into a new recession, which hit the continent's periphery even harder.

Germany is the Eurozone state that is most opposed to the role of the ECB as lender of last resort to governments, a role that is perfectly accepted by all in Anglo-Saxon countries or Japan: the government intervenes in the debt markets by buying or selling bonds to guarantee the liquidity of the state. The idea that the central bank can create money out of nothing to lend to governments, one of the causes of the hyperinflations of the 1920s, causes a lot of nervousness in large sections of German society, even if it is done in a controlled manner.

The other side of the coin is the German obsession with public deficits: since the central bank cannot create money or buy public debt, governments must give priority to keeping public coffers healthy, since if they get too indebted there is no government support institution to reduce the accumulated liabilities.

Hungary, Venezuela and Zimbabwe

The German episode may be the best known and most studied, but it is not the most severe: the most intense hyperinflation in history was that of Hungary in 1946, during the Soviet occupation of the country after World War II and the establishment of the unstable Second Republic (which was eventually forcibly abolished by Moscow) and replaced by a communist regime. At the height of the inflationary episode, product prices doubled in less than 15 hours. In July of that year, the annual rate of price growth reached the absurd figure of 41,900,000,000,000,000% (41.9 trillion percent).

In fact, the years immediately following the Second World War were marked by sharp price increases in several countries affected by the conflict, such as China or Greece. The former Yugoslavia in 1994, during the Balkan War, or Zimbabwe in 2008, are more recent examples of hyperinflation: in both cases prices doubled in two days. And in recent years we have the example of Venezuela, where in 2018 prices grew on average by 1,000,000% (one million percent), according to the country's central bank.

Starting from scratch

What solutions can there be to inflation of this kind? In the end, the "only solution" if citizens lose faith in the value of their currency is to create a new one from scratch, Pons recalls. "Making a reset", he adds.

Another way out, although according to Pons it is more "risky", is to adopt a foreign currency, either directly or through a fixed exchange rate, as Argentina did in a previous episode. This option has the problem that it involves "ceding sovereignty" to another country, since it depends on a country that is worthless. This is a problem, especially when citizens are already accumulating dollars because their currency is worthless.