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Report 2/2009 Will we be hit by hyperinflation? Stefan Bruckbauer / [email protected] The central banks and finance ministers have so far responded very well to the financial market crisis. As the recovery process, especially on the capital market, gets underway, there are growing fears that the measures implemented could ultimately lead to hyperinflation as experienced before the Second World War. We believe these fears are exaggerated. Once again, there were fears that the government would reduce debt at the expense of inflation as 1931 briefly saw a sharp increase in the money supply. The latter soon returned to previous levels, however. The memories of the 1920's were still very fresh, and the schilling moreover also came under pressure. The central bank responded with restraint, and this finally ended in a deflationary policy. Consumer prices fell in 1931; in Austria, prices tumbled by 5% in the years 1929 to 1934, in Germany by as much as 20%. The depression that was triggered by the economic slump and the sudden increase in government debt therefore led to deflation, and not inflation. Nor did Austria experience any inflation in subsequent years, until the beginning of the Second World War. In the wake of the financial market crisis, central banks and finance ministers in many countries resorted to measures which can be compared only with those taken before the Second World War. Especially the strong expansion of claims by central banks, which exceeded 50% in the case of the ECB and 150% at the Federal Reserve, is fuelling fears of inflation. The fact that in most of the world's countries government debt will be increasing by 15 or more percentage points of GDP is driving fears that governments will reduce indebtedness at the expense of higher inflation. A negative example that is often cited in this connection are the developments in Austria between the two World Wars. Developments after 2009 The developments of the 1930's show that a sharp economic downturn, which significantly raises the level of government indebtedness and results in a marked increase in central bank claims, is not necessarily followed by high inflation or hyperinflation. Hyperinflation in the 1920's, depression in the 1930's An analysis of developments in that period reveals that events were contrary to such fears. Austria experienced hyperinflation in 1922 with an inflation rate of over 2,500%. With the exception of 1923 (-1%), economic growth in the remaining 1920's was always positive. The sharp economic downturn did not come until 1930 with the subsequent collapse of the banks (which peaked in 1931). This was followed by three additional years of negative growth rates; overall, Austria's GDP contracted by a real 22%. The number of unemployed jumped from 190,000 in 1929 to 560,000 in 1933. This corresponds to an unemployment rate of 26%. As the crisis progressed, government debt initially rose by 20% until 1932, but subsequently by a total 70% until 1934. This represents an increase of 17% to 40% of GDP. An appraisal of developments after 2009 depends on the extent to which central banks can maintain their independence. The ECB's independence appears to be assured, partly through the treaty establishing the European Community, and partly through the difficult decision-making processes within the EU. Today, it seems difficult, if not impossible, for EU finance ministers to agree on changes to ECB policy. One can therefore assume that the ECB will continue to pursue its objective of medium term price stability. This means that after the economic downturn has passed its nadir, the ECB will have to reassess the impact of the money supply and the capacity utilisation levels of the European economy. Inflation 1920 to 1938 Real GDP 1929 to 1934 compared to 2008 to 2011 (per cent change over previous year, Austria) (1929=100 and 2008=100, Austria) 3000% 105 2544% 2500% 2008 2009 2010 1929=100 2011 1929 1930 1931 2008=100 100 2000% 95 1500% 90 1000% 85 500% 105% 95% 0% 142% 17% 9% -2% 3% 2% 3% 0% 2% -3% 0% 0% 0% 0% -5% -500% 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 Source: Cipolla, Borchardt (1980): Die europäischen Volkswirtschaften im zwanzigsten Jahrhundert; Bachinger (1987) "Österreich von 1918 bis zur Gegenwart", Bank Austria June 2009 80 75 1932 1933 1934 Source: Monatsberichte des Wifo, Sonderheft 14 (1965) , Bank Austria Bank Austria Economics & Market Analysis Report 2/2009 High money supply level is not automatically an inflationary threat During the crisis, the ECB's claims (mostly against banks), that is, funding, have risen by 70% until March 2009. The increase has meanwhile receded to 50% compared with year-end 2007. The money supply has expanded by only 15%, and lending volume by no more than 12%. The latter has moreover been stagnating in the euro area since autumn 2008. The increase in the ECB's total assets therefore does not pose any threat to inflation. In the course of the recovery process it will however not be so easy for the ECB to decide whether the seeds of inflation are sown by an increase in the money supply or in lending volume. The correlation between lending volume and inflation has never been very clear, and the connection between money supply and inflation has been a very contentious issue. For this reason, one can expect a very lively public debate as to whether the trend in the money supply is also a threat to inflation. What is Europe's potential growth? But inflation is not defined by the money supply, or possibly only to a very small extent. It is the full utilisation of capacity which is the decisive factor for inflationary pressure. In an economic context, this is reflected in the gap between actual output (GDP) and potential output (potential GDP). Although this explanation sounds very simple, the practical implementation of this concept requires some very difficult assumptions. As monetary policy has a lead time of at least one year, it has to rely on forecasts. In addition, it has to make assumptions as to where the potential of the euro area economy lies, and on the extent of potential growth. This has been very difficult to do in the past and is unlikely to be any easier after the historic economic slump. Based on figures of Bank Austria's Government indebtedness 1929 to 1934 compared to 2008 to 2011 (1929=100 and 2008=100, Austria) 1929=100 economic forecast for Austria (-3.5% for 2009, -0.3% for 2010 and 1.4% for 2011) and on the assumption of potential growth of 3%, there is at the end of 2011 still an output gap of about 10% of GDP. If one assumes that potential growth will be 1.5%, the output gap narrows to about 4%. In the first case, monetary policy would still have plenty of time to raise interest rates, even if the Austrian economy were to grow by over 3%. In the second case, the makers of monetary policy would already need to respond now. Based on past experience one may assume that the ECB is more likely to respond to signs of recovery too early rather than too late. Reduction of government debt via inflation only possible to a limited extent Even if one were to assume that the ECB will change its policy of independence which it has pursued until now, or abandon its primary objective of reaching an inflation rate of 2%, the question is whether governments can in fact reduce their debt through inflation. Even if it is undisputed that the debt burden (in real terms) can be shouldered more easily if the inflation rate is higher, which is reflected in a falling debt ratio (government debt in per cent of GDP), this cannot be achieved without expense. In light of the experience associated with the introduction of the euro, when public sentiment over the rise in inflation was very negative, one may ask whether the government is really interested in reducing the debt burden (in real terms) via inflation which is perceived in such negative terms by the public. It is much more likely that the government will try to boost revenue and/or reduce public services. A higher rate of inflation would moreover increase the interest payable on government debt. A realistic simulation shows that inflation of 5% per annum would in the next ten years reduce Austria's debt ratio only marginally, from 74% to 68%. Development of prices 1929 to 1934 compared to 2008 to 2011 (1929=100 and 2008=100, Austria) 2008=100 1929=100 105 2008=100 Deutschland, 1929=100 180 100 170 160 95 150 90 140 130 85 120 80 110 100 75 1929 2008 1930 2009 Source: The Journal of Economic History , Bank Austria 2 June 2009 1931 2010 1932 2011 1933 1934 1929 2008 1930 2009 1931 2010 1932 2011 1933 1934 Source: Cipolla, Borchardt (1980): Die europäischen Volkswirtschaften im zwanzigsten Jahrhundert;The Journal of Economic History , Bank Austria Bank Austria Economics and Market Analysis