Hyper­in­fla­tion para­noia guides the Fed

The Pak Banker - - OPINION - Noah Smith

MOVE over Zim­babwe: Venezuela has re­placed you as the poster child for mon­e­tary disas­ter. Cit­i­zens of that coun­try are car­ry­ing back­packs of cash to buy their daily ne­ces­si­ties. Prices there are ex­pected to rise by 720 per­cent this year, mak­ing Venezuela's hyper­in­fla­tion the most se­vere on planet Earth. But what is hyper­in­fla­tion, any­way? Al­though economist­stra­di­tion­ally set the thresh­old at 50 per­cent an­nual in­fla­tion, I pre­fer In­vesto­pe­dia's def­i­ni­tion:

There is no pre­cise nu­mer­i­cal def­i­ni­tion to hyper­in­fla­tion. Hyper­in­fla­tion is a sit­u­a­tion where the price in­creases are so out of con­trol that the con­cept of in­fla­tion is mean­ing­less. That is bril­liant, be­cause it cap­tures the ab­nor­mal­ity of the phe­nom­e­non. What Amer­i­cans think of as high in­fla­tion -- for ex­am­ple, the 12 per­cent or 13 per­cent an­nual rates in late 1979 and early 1980 -- just seems like a fun­da­men­tally dif­fer­ent an­i­mal from the 1,000-plus-per­cent rates seen in the past in coun­tries like Zim­babwe, Ar­gentina or Weimar Ger­many.

Not all econ­o­mists make this dis­tinc­tion. The famed macroe­conomist Thomas Sar­gent, for ex­am­ple, wrote an eco­nomic his­tory pa­per in 1981 called "The Ends of Four Big In­fla­tions." Sar­gent con­cluded that hy­per­in­fla­tions ended when cen­tral banks cred­i­bly promised to stop print­ing large amounts of money. The im­pli­ca­tion is that if the U.S. cen­tral bank loses its cred­i­bil­ity -- if peo­ple be­lieve that the Fed­eral Re­serve is will­ing to print money with­out limit -- then the dol­lar could eas­ily suf­fer the same fate as the Venezue­lan bo­li­var.

That helps to ex­plain why Fed pol­icy mak­ers are para­noid about los­ing their in­fla­tion-fight­ing cred­i­bil­ity -- so much so that they re­fused to con­sider even a 4 per­cent in­fla­tion tar­get dur­ing the Great Re­ces­sion. Even so, the Fed's quan­ti­ta­tive eas­ing caused hawk­ish macroe­conomists like the Univer­sity of Chicago's John Cochrane to warn in 2009 that the U.S. was in dan­ger of hyper­in­fla­tion.

Per­son­ally, I'm not very sat­is­fied with the con­sen­sus opin­ion. Given the dis­as­trous con­se­quences of hyper­in­fla­tion, and how much the fear of it in­forms pol­icy mak­ing, there re­ally ought to be a lot more re­search on this topic than there is. Econ­o­mists and pol­icy mak­ers ba­si­cally bought Sar­gent's story from the early '80s and haven't re­vis­ited it. But maybe they should. Hy­per­in­fla­tions tend to hap­pen in coun­tries with political prob­lems. Venezuela's govern­ment, for ex­am­ple, has been try­ing to trans­form a cap­i­tal­ist econ­omy into a so­cial­ist one, while at the same time plac­ing con­straints on the coun­try's demo­cratic in­sti­tu­tions. The famed Weimar hyper­in­fla­tion oc­curred af­ter Ger­many lost a huge war and amid se­vere ex­ter­nally im­posed war repa­ra­tions, and also in­volved an un­sta­ble govern­ment. Ar­gentina and Zim­babwe were sim­i­larly un­der­go­ing highly un­sta­ble political tran­si­tions. This should be a clue that hyper­in­fla­tion is at least partly a political phe­nom­e­non, not just an eco­nomic one.

An­other odd thing about hyper­in­fla­tion is how fast it hap­pens. The very sud­den and enor­mous de­pre­ci­a­tion of a cur­rency's value looks a lot like the col­lapse of an as­set bub­ble, a run on a bank, or sud­den cap­i­tal flight from a destablized emerg­ing mar­ket. Econ­o­mists have sug­gested that th­ese phe­nom­ena are due to co­or­di­na­tion prob­lems -- ev­ery­one try­ing to flee for the ex­its at the same time, try­ing to get out first. Hyper­in­fla­tion looks an aw­ful lot like a run on a cur­rency.

That sug­gests that hyper­in­fla­tion is not sim­ply a more se­vere form of the sort of in­fla­tion the U.S. saw in the 1970s. Nor­mal macroe­co­nomic mod­els, which are de­signed to al­low for '70s-style in­fla­tion, don't say any­thing about what would cause a whole­sale run on a cur­rency. Pre­sum­ably, a sud­den loss of cen­tral bank cred­i­bil­ity might be the trig­ger, but there could also be many other causes. For ex­am­ple, the avail­abil­ity of an al­ter­na­tive cur­rency -- U.S. dol­lars, euros, gold or bit­coin -- might raise peo­ple's will­ing­ness to aban­don their lo­cal money. Political in­sta­bil­ity also prob­a­bly fig­ures into the equa­tion -- if peo­ple be­lieve that a dic­ta­tor or for­eign oc­cu­piers will com­man­deer the cen­tral bank for their own pur­poses, that might make hyper­in­fla­tion much more likely. So econ­o­mists should be work­ing much harder on un­der­stand­ing why hy­per­in­fla­tions hap­pen. The ques­tion is es­pe­cially im­por­tant for coun­tries like Ja­pan, where huge govern­ment debts, ag­gres­sive mon­e­tary pol­icy and neg­a­tive in­ter­est rates have raised the specter of hyper­in­fla­tion, but where political sta­bil­ity is strong and cred­i­ble al­ter­na­tive cur­ren­cies don't re­ally ex­ist.

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