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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