Friedman on Inflation, Hanke on Hyperinflation
In 1966, Milton Friedman wrote, as he often did, some memorable lines that have entered the lexicon of economic quotables. As Friedman correctly put it in a book chapter titled “What Price Guideposts?”: “Inflation is always and everywhere a monetary phenomenon, resulting from and accompanied by a rise in the quantity of money relative to output…. It follows that the only effective way to stop inflation is to restrain the rate of growth of the quantity of money.”
While true, Friedman’s classic statement doesn’t tell us anything about what drives the growth of the money supply that fuels inflation. The importance of this omission becomes particularly important in hyperinflations, when the monthly inflation rate exceeds 50% for thirty consecutive days. Hyperinflations are rather rare. There have only been 58 episodes of hyperinflation in recorded history. The first episode occurred in France, where the mandat collapsed. In August 1796, France’s monthly inflation rate peaked at 304%. Today, there is only one hyperinflation, Venezuela’s. I measure both Venezuela’s monthly and annual rate of inflation with high-frequency data each day. On August 27th, Venezuela’s monthly rate of inflation was 177% and its annual rate of inflation was 60,934%.
Many people ask, how can this be? What drives the money supply and inflation to astronomical heights? To answer these questions, we must go behind Friedman’s heavily quoted words.
In hyperinflations, the “printing presses” go into overdrive because governments spend, and all the sources for funding their largess either never existed or wither away, except one: central banks. To set the stage, in a pre-hyperinflation situation, when a full array of financing options are available, government expenditures can be financed by taxes, by the domestic and international bond markets, by revenue from state-owned enterprises, and by central banks. In addition, governments can defer payments by accumulating arrears. So, arrears are also a means of “funding.” Governments can also go hat-in-hand to obtain foreign aid, yet another source of funding.
When the Soviet Union collapsed, there was an outbreak of hyperinflation episodes. Indeed, 21 of the 58 world hyperinflation episodes occurred in newly independent countries of the former Soviet Union. Why? Well, under communism, there were no “taxes” and no tax administrations for assessing and collecting taxes. So, the newly independent states were not set up to levy and administer taxes. In addition, they had, at best, only fledging domestic bond markets, and for the most part, their access to international bond markets was limited. So, they initially piled up mountains of arrears and passed the begging bowl. But, eventually, their fiscal authorities went to their central banks and forced them to purchase the governments’ obligations. That is when the printing presses were turned on, and the money supplies surged. And, so did inflation.
In addition to the hyperinflation episodes in countries of the former Soviet Union, there were seven episodes in the early 1990s in countries that had abandoned communism, like Bulgaria, Poland, and Yugoslavia. These countries all, in varying degrees, faced the same government funding problems as did those in the former Soviet Union. Almost half of the 58 recorded hyperinflations occurred in the 1990s and were the result of the funding deficiencies associated with the new post-communist states.
I became very familiar with one of these countries. In 1990, I became the chief adviser to the first post-communist government in Yugoslavia. With the ascendancy of Slobodan Milosevic and the outbreak of the civil war in 1991, I bid Yugoslavia fare well. But, not before learning a great deal about how Yugoslavia’s unusual brand of communism worked.
The post-communist Yugoslavia faced many of the same problems that other post-communist countries faced. However, Yugoslavia was different than the others in several important respects. For example, it had an endemic, open inflation problem. During the twenty year period 1971-1991, Yugoslavia’s inflation rate averaged 76% per year. Only Zaire and Brazil had worse records.
Yugoslavia also had a tax system. But, the never ending Yugoslav inflation created problems with taxes as a source of government funding. Indeed, the inflation, when mixed with taxes, was a deadly cocktail. My good friend Vito Tanzi figured out just how deadly that cocktail is while he was working in Argentina during the 1970s. Tanzi found that when inflation was elevated and rising, government revenues from taxes plunged because of what has become known as the “Tanzi Effect.”
How does the Tanzi Effect work? There is an interval between the occurrence of a “taxable event” and the actual payment of taxes to the government. When inflation is elevated and rising, the destruction of the real value of the taxes levied can become very important. For example, if a tax collection lag is only one month and the inflation rate is 50% per month, the threshold rate to qualify as a hyperinflation, inflation would result in a 50% reduction in the real value of the taxes levied. So, the Tanzi Effect, which Tanzi devotes a chapter to in his new fascinating book, Argentina from Peron to Macri: An Economic Chronicle, describes the dynamics of the withering away of taxes as a source of finance during a hyperinflation.
Today, Venezuela’s tax base is in the grips of the Tanzi Effect. This means that the government must rely more-and-more on central bank financing than would be the case absent hyperinflation. In short, Venezuela is in a doom loop. This is thanks, in part, to the Tanzi Effect.
These hyperinflation doom loops can reach extremes. Yugoslavia is but one example. In January of 1994, the monthly rate of inflation reached a stunning 313,000,000%, the third highest hyperinflation in recorded history. At that time, my friend and collaborator Zeljko Bogetic and his colleaguesdetermined that virtually all of Belgrade’s revenue sources had dried up. In consequence, an astounding 95% of government expenditures were being financed by the central banks’ printing press.
All this printing, the collapse of the dinar, and hyperinflation infuriated Slobodan Milosevic. Among other things, I became a marked man. The Yugoslav Information Minister, Goran Matic, produced a steady stream of bizarre stories about my alleged activities. These were disseminated via the Yugoslav state news agency, Tanjug. Among other allegations, I was accused of being the leader of a smuggling ring that was destabilizing the Serbian economy by flooding it with counterfeit Yugoslav dinars. The most spectacular accusation, however, was that I was a French secret agent who controlled a hit-team code-named "Pauk" ("Spider"), and that this five-man team’s mission was to assassinate President Milosevic.
Politicians never take responsibility for creating hyperinflations. They always place the blame somewhere else. But, the cause is always the same. As traditional funding sources dry up, the central bank’s printing presses go into overdrive, as they become the only funding source for the government’s largess. And with that, hyperinflation raises its ugly head.