Does public money creation always lead to hyperinflation?

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Throughout history, governments have used their ability to create money to fund public spending. While none of these policies were called, “People’s QE”, “Strategic QE”, “Sovereign “Money Creation”, or “Helicopter Money” (what Positive Money collectively refers to as Public Money Creation), they shared the common trait of using newly created state money to finance government spending, rather than relying on commercial banks to create new money through lending.

The common response to the idea of allowing the state to issue money and spend it into the economy is that such an approach would be highly infla­tionary. In our previous post on this topic, we showed that theory and analysis have been dispensed with at the expense of this widespread misconception. In this post, we will show that misleading conclusions have been drawn from the case studies of state-led money creation in Zimbabwe and the Weimar Republic.

The empirical reality, both when looking at quantitative data and qualitative descriptions of what actually happens in hyperinflations shows that they are not the results of well-governed states abusing the money creation process.

Rather, hyperinflation is typically a symptom of some underlying economic collapse, as happened in Zimbabwe and Weimar Republic Germany.

While inflation can be described as a general increase in the price level, or equivalently a fall in the purchasing power of a currency, hyperinflation is a different phenomenon entirely. Although definitions are in general rather arbitrary, many economists distinguish hyperinflation from merely high infla­tion by defining it as a price level increase of at least 50% per month (Cagen, 1956). This is in contrast with ‘normal’ inflation, which many countries, including the UK, target at 2% a year. Fortunately, hyperinflations tend to be rare, with around 57 occurrences in modern economic history including the most recent case which is occurring now in Venezuela.

The examples of the hyperinflation in Zimbabwe or Weimar Republic Germany are all too often mentioned as a reason why states cannot be trusted to issue currency. However, those making these claims rarely have any in-depth understanding of what happened in Zimbabwe, Germany or any of the other hyperinflationary periods.

In reality, each period of hyperinflation happens due to a unique set of circumstances that are completely inapplicable to the UK or any of the countries where these reforms are likely to be implemented. A Cato Institute study of all 56 recorded hyperinflations found that hyperinflations only occur under extreme conditions such as war or a complete collapse in the productive capacity of a country. Hyperinflation has never been a consequence of monetary policy or politicians turning on the printing press just before an election; rather, hyperinflation is a symptom of a state that has lost control of its tax base.

In Modernising Money, they show that the wrong lessons have been learned from the Zimbabwe and Weimar case studies. The following analysis is based on the aforementioned book:

After gaining independence in 1980, Zimbabwe was on its way to prosperity, with an average GDP growth rate of 4.3 percent a year. For about two decades it experienced sustained growth, which was only occasionally interrupted. The country is endowed with rich resources and mineral reserves, possessing huge deposits of diamonds, gold, nickel, iron, platinum, coal and other natural goods. Compared to other African countries, it had a sophisticated industry manufacturing textiles, cement, chemicals, steel, wood and other products. Agricultural production, the mainstay of its economy, is supported by 10,747 dams (out of 12,430 water dams in the entire Southern African region) (Sugu­nan, 1997). The tobacco industry was Zimbabwe’s most successful generator of foreign exchange, earning about US$600 million in 2000. Zimbabwe was also a popular tourist destination. Perhaps most important to Zimbabwe was its strong banking sector and a well-functioning property rights system, which “allowed owners to use the equity in their land to develop and build new busi­nesses, or expand their old ones” (Richardson, 2005, pp.1).

However, by the end of the 1990s Zimbabwe’s economic progress came to a halt and the country’s economy entered into a depression. What caused this turnaround? Media reports often simplistically imply that the printing of money was the cause of Zimbabwe’s economic collapse. However, in reality the economic collapse came first, and the mass printing of money came as a consequence of this.

Zimbabwe’s president, Robert Mugabe, and other members of the leading party ZANU-PF, have been eager to blame the economic decay on the continuous years of drought and the targeted sanctions of Western countries. Yet these claims are easily refuted: sanctions on top government officials only came into effect in 2002. Empirical research questions the claim that drought is to blame: “The historically close relationship between rainfall and GDP growth ended in 2000 – the first years after the land reforms.” (Coltart, 2008, p. 10).

So what were the real reasons for Zimbabwe’s decline? In the mid 90s, about 4,500 white families owned most of the commercial farms, employing 350,000 black workers and often providing financial support for local infrastructure, hospitals and schools. Simultaneously about 8,500 black farmers ran small-scale commercial farms that were able to access credit from Zimbabwean banks and vitally contributed to the agricultural production (Richardson, 2005). However, the prevalence of white farmers in agricultural production – commonly viewed as a heritage of colonialism – sparked negative sentiment, and fuelled calls by Mugabe and others to return the fertile ‘stolen lands’ to black Zimbabweans (Hill, 2003, p. 102).

Nevertheless, these conflicts did not constrain the growth of the economy until the rhetoric was acted on. The ‘point of no return’, according to Coltart (2008), took place in 1997 with three crucial developments. The first was that the war veterans, who fought for independence and had traditionally been loyal to the ZANU-PF, became ever more disgruntled with the ruling elite’s growing wealth and began demanding a bigger stake. In response, Mugabe committed to increase pension payments and other forms of benefits. Secondly, Mugabe ordered an expensive deployment of the Zimbabwean military in the Demo­cratic Republic of Congo (which lasted until 2003), in order to support the regime of Laurent Kabila, and in so doing protect the mining investments made by members of the Zimbabwean ruling elite. Thirdly, and probably most crucially, the Zimbabwean government finally began to make good on its threats to acquire vast tracts of land that were owned by the white commercial farmers.

Whilst the first two events increased government spending, the third lowered production and exports, which reduced tax revenues. This rise in government spending and fall in government income was “the beginning of the Zimbabwean’s economy’s downward spiral”. The effect of the Land Reform was several fold Firstly, foreign investors fled, fearing their assets could be seized next. By 2001 foreign direct investment in Zimbabwe fell to zero, whilst the World Bank’s risk premium on foreign investment rose from 4% to 20%. Secondly, the non-enforcement of land titles removed a major source of collateral for bank loans. As a result lending to farmers dried up, and investment in agriculture plummeted. Thirdly, those farmers who were evicted found themselves unable to pay back their loans. This, combined with the loss of income from farm loans, lead to dozens of banks collapsing, with massive negative repercussions for Zimbabwean businesses. Fourthly, the land redistribution, although supposedly meant to benefit the poorest Zimbabweans, actually largely benefited the ruling elites who cherry picked the most fertile farmlands. With the commercial farmers deserting Zimbabwe, crop yields collapsed and famine ensued. Fifth, land values collapsed due to the removal of property rights, and with it much of Zimbabwe’s wealth.

With such a large loss in output, tax revenue also fell dramatically. Combined with the increase in spending, the government’s budget came under severe pressure. This was exacerbated in 2001 when the government defaulted on the servicing of its loan from the International Monetary Fund (IMF). In response, the IMF refused to make any concessions (such as refinancing or loan forgiveness) to punish the government for its policies, most significantly the land reform measures. With reduced food production due to the land reforms, the government had to buy food from abroad to try to prevent mass starvation. But, because of the default on the IMF loan, Zimbabwe’s creditwor­thiness was effectively ruined, making it impossible to get loans elsewhere. As a result, the Zimbabwe government started to issue its own national currency and used the money to buy U.S. dollars on the foreign-exchange market. The attempt by the government to plug the increasing deficit between spending and revenue through the creation of money increased the purchasing power in the economy, just as the fall in output in the agricultural and manufacturing sector decreased the amount of goods available to purchase. The result was the classic case of ‘too much money chasing too few goods’. High inflation ensued, with annual rates above 100% from 2001. By 2003 the value of the Zimbabwe dollar had deteriorated to such an extent that it was costing the government more to issue the notes and coins than they were worth at face value. In light of this the government began issuing time-limited ‘bearer checks’ in very high denominations.

After defaulting on the IMF loan, the situation in Zimbabwe rapidly deterio­rated, with each new political measure from ZANU-PF aimed solely at keep­ing a hold on power. It achieved this goal by shuffling aside any opposition, and by appropriating the country’s resources through the confiscation and redistribution of privately owned assets. This included killing representatives of the opposition and several white farmers in order to occupy their lands. The intimidation of not only the political opposition and the judiciary but the whole population became crucial to maintain political and economic power. For example, in 2004 human rights groups reported that about 90 percent of the opposition members suffered from criminal violation, 24 percent had been subjected to potentially lethal attacks and 42 percent had been tortured.

By 2005, economic conditions had grown particularly bad. More than 80 percent of the Zimbabwean population was officially unemployed. The infor­mal sector of the economy, which accounted for less than 10% of the total in 1980, was by 2005 the main source of income for the majority of Zimbabwe­ans: more than 3 million people worked in the informal economy compared to only 1.3 million in the formal sector (Tibaijuka, 2005). With economic condi­tions rapidly worsening, the government resorted to extreme measures to both bolster its position and get the economy under control. For example, in 2005 the government implemented a law which required exporters to sell up to 30 percent of their foreign exchange earnings to the Zimbabwe Reserve Bank at an artificially low exchange rate. This immediately imposed a huge cost on the manufacturing sector, which was exacerbated when the Zimbabwean dollar was strengthened due to foreign aid (as the price of their exports, in terms of other currencies, increased while the price of imports decreased). With costs also rapidly increasing (particularly interest rates) local manufacturers were struggling to survive (Coltart, 2008).

Further pressure was placed on the economy through government attempts to control inflation. However, inflation continued to rise, with price rises reach­ing the 50% a month necessary to be classified as hyperinflation by mid to late 2007 (McIndoe, 2009). The government continued to attempt to restrict infla­tion, including through direct price control mechanisms in 2007 yet with little success. Prices continued to increase, and every economic indicator markedly worsened.

To help cover the shortfall on the Zimbabwean government’s shrinking income, the Reserve Bank of Zimbabwe increased the amount of currency in circulation at an alarming rate after 2003, leading to the introduction of the second Zimbabwe dollar in 2006, at a value of 1000 old Zimbabwe dollars and devalued 60% against the US dollar. This was followed by a further devalua­tion of 92% in 2007. The third Zimbabwe dollar was introduced in 2008 at 10billion times the second Zimbabwe dollar (Noko, 2011).

By November 2008, the rate of inflation in Zimbabwe had peaked at 79.6 billion percent per month (Hanke & Kwok, 2009). In the build up to the inflationary peak, prices were revised upwards at an ever faster pace, in daily, hourly or within even shorter periods. The prices of goods in Zimbabwean dollars were updated vis-à-vis the exchange rate of foreign currencies, which were exchanged in a currency black-market in the streets, shops and backyards where people tried ‘to get rid of their Zimbabwean dollars’ as soon as they got them (The Economist, 2008). With the value of the Zimbabwean dollar decreasing vis-à-vis other currencies at an ever-increasing rate, ‘dollarisation’ the use of US dollars instead of the local currency – became widespread as “people simply refused to use the Zimbabwe dollar” (Hanke & Kwok, 2009, p. 354). By February 2009 the authorities officially recognised the demise of the Zimbabwean dollar, and a ‘multi-currency system’ was adopted. This brought to an end ten years of high inflation and two years of hyperinflation. As a result the price level (in US dollars) stabilised, and the economy started to recover. Bank accounts denominated in Zimbabwe dollars were suspended at the current exchange rate of Z$35 quadrillion to US$1 (IMF, 2010).

In the end, the damage done to the Zimbabwean economy was staggering. Between 2000 and 2008 output contracted by 40 percent, while the govern­ment’s budget revenue fell from more than 28 percent of GDP (in 1998) to less than 5 percent (in 2008). This resulted in the:

“almost total collapse in public services. By the end of 2008, most schools and many hospitals had closed, transport and electricity networks were severely compromised, and a water-borne cholera epidemic had claimed more than 4,000 lives.” (IMF, 2010, p. 51)

In conclusion, it was the struggle to maintain political power that led the Mugabe regime to implement policies that caused a significant fall in the productive capacity of what had been a prosperous and growing economy. This fall in output, and the consequent fall in tax revenues (combined with some expensive military forays) squeezed government revenues further. The expropriation of farmland in order to appease political allies destroyed Zimbabwe’s agricultural sector, with subsequent detrimental knock-on effects on other economic sectors. Consequently tax revenues fell dramatically, and with government expenditures increasing (again to appease political allies) the government, via its control of the Reserve Bank of Zimbabwe (and there­fore political control of money creation) was forced to turn to the printing of money to fill the gap.

So, while the hyperinflation was made possible by the printing of money, it is not the case that money printing always leads to high or hyper-inflations. Rather, it was the printing of money to finance expenditure, with no regard for the inflationary consequences, and the preceeding collapse in the productive capacity of the economy, which pushed Zimbabwe into hyperinflation. Had Zimbabwe’s central bank been independent of politicians, and focused on price stability rather than facilitating government spending (with more careful control over money creation), the hyperinflation would have been impossible.

Germany’s hyperinflation of 1923 is also typically held up as an example of the dangers of money creation by governments. A recent working paper by economists at the IMF unpicks this common interpretation of events:

“The Reichsbank president at the time, Hjalmar Schacht, put the record straight on the real causes of that episode in Schacht (1967). Specifically, in May 1922 the Allies insisted on granting total private control over the Reichsbank. This private institution then allowed private banks to issue massive amounts of currency, until half the money in circulation was private bank money that the Reichsbank readily exchanged for Reichs­marks on demand. The private Reichsbank also enabled speculators to short-sell the currency, which was already under severe pressure due to the transfer problem of the reparations payments pointed out by Keynes (1929). It did so by granting lavish Reichsmark loans to speculators on demand, which they could exchange for foreign currency when forward sales of Reichsmarks matured. When Schacht was appointed, in late 1923, he stopped converting private monies to Reichsmark on demand, he stopped granting Reichsmark loans on demand, and furthermore he made the new Rentenmark non-convertible against foreign currencies. The result was that speculators were crushed and the hyperinflation was stopped. Further support for the currency came from the Dawes plan that significantly reduced unrealistically high reparations payments.”

The authors of the working paper concluded that, “this episode can therefore clearly not be blamed on excessive money printing by a government-run central bank, but rather on a combination of excessive reparations claims and of massive money creation by private speculators, aided and abetted by a private central bank.”

The empirical reality, both when looking at quantitative data and qualitative descriptions of what actually happens in hyperinflation, shows that they are the results of poorly governed states abusing the money creation process.

Indeed, the case study of Weimar Republic shows that it was not even Public Money Creation but private bank money creation that triggered hyperinflation.

The lessons from the above case studies suggest that hyperinflations do not happen simply because of an increase in money creation; indeed, the private banking sector in the UK more than doubled the money stock from 1997-2007 and they did not experience hyperinflation. Hyperinflation in Germany and Zimbabwe was preceded by a fundamental collapse in the productive capacity of the economy, which started the inflationary pressure.

In both cases the economy collapsed and the government could not mobilize resources via taxation to fund expenditure. As was the case in Zimbabwe, desperate for funds, the government resorted to financing their spending through money creation. Hyperinflation was thus not a consequence of monetary policy but a symptom of a state that has lost control of its tax base.

Both the Weimar and Zimbabwe case studies show that there is a danger when those with the power to create money can also benefit from its creation. This is why Public Money Creation proposals, stress the importance of having a strict separation of powers as well as appropriate institutional checks and balances. In these proposals, elected politicians would decide how to use the newly created money, while the independent administrative branches of central banks would decide how much money to create. This separation of powers would prevent politicians from being given direct control over money creation, avoiding the risk that political pressures could lead governments to abuse this power. Similarly, this process is designed so that the administrative branches of the central bank have no say how public money is used.

In deciding how much new money should be injected into the economy the central bank would be instructed to consider the needs of the economy as well as its mandate of keeping inflation low and steady. As soon as indicators suggested that the level of money creation was becoming excessive (i.e. if inflation started to exceed 2%) then the central bank could slow down or stop the rate at which new money was being created.

All of the above sections were authored by Frank Van Lerven, December 4, 2015  (A HISTORY OF PUBLIC MONEY CREATION PART 2 OF 8) HYPERINFLATION: HOW THE WRONG LESSONS WERE LEARNED FROM WEIMAR AND ZIMBABWE, go to https://positivemoney.org/?s=a+history+of+public+money

Cagen, P. (1956). The Monetary Dynamics of Hyperinflation. In: M. Fried­man. (1956). Studies in the Quantity Theory of Money. Chicago: University of Chicago Press.

Coltart, D. (2008). A Decade of Suffering in Zimbabwe. Economic Collapse and Political Repression under Robert Mugabe. Economic Develop­ment Bulletin, March 24th.

Hanke, S., & Kwok, A. (2009). On the Measurement of Zimbabwe’s Hyperin­flation. Cato Journal, 29 (2), (pp. 353-364).

Hill, G. (2003). The Battle for Zimbabwe. Cape Town: Zebra.

IMF. (2010). Zimbabwe: Challenges and Policy Options After Hyperinflation. Washington D.C: International Monetary Fund.

McIndoe, T. (2009, July 31st). Hyperinflation in Zimbabwe: Money Demand, Seigniorage and Aid Shocks. IIIS discussion paper No. 293. Institute for Inter­national Integration Studies.

Noko, J. (2011). Dollarization: The Case of Zimbabwe. The Cato Journal, 31 (2), (p. 339).

Richardson, C. (2005), How the Loss of Property Rights Caused Zimbabwe’s Collapse. Economic Development Bulletin, November 14th 2005.

Schacht, H. (1967), The Magic of Money, translation by P. Erskine, London: Oldbourne.

Sugunan, V. (1997). Fisheries Management of Small Water Bodies in Seven Countries in Africa, Asia and Latin America. Rome: Food and Agriculture Organization, United Nations.

The Economist. (2008, July 17th). A Worthless Currency. Retrieved December 7th, 2011.

Tibaijuka, A. K. (2005). Report of the Fact-Finding Mission to Zimbabwe to Assess the Scope and Impact of Operation Murambatsvina by the UN Special Envoy on Human Settlements Issues in Zimbabwe. United Nations.