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What can we learn from unprecedented price rises in US, and Germany in the last millennium?

No macroeconomic indicator has as much impact on the society as hyper-inflation does

High inflation has been the talk of the town. In June, the retail inflation in the United States was at 9.1 per cent, the highest it has been in more than four decades. In Turkey, the inflation in June was at a whopping 78.6 per cent — the highest in more than two decades. Inflation has become a reality in countries across the world and is proving stubborn to get rid of.

No macroeconomic indicator has as much impact on the society as inflation does. Most people don’t follow economic growth figures of their countries but start to feel the pinch as soon as prices start to go up. Inflation is the rate of price rise.

Hence, it becomes very important to understand the causes behind inflation, how they impact the society-at-large and what can possibly be done to control it.

The best way to look at the present is to look at the past. To do this, we will look at two historical episodes of inflation.

The German hyperinflation of 1923 and the high inflation in the US in the late 1970s and early 1980s.

These two different bouts of inflation will help us understand the reasons behind inflation as it prevails in the world at large today and what can be possibly done about it.

The classical gold standard

Before 1913 most countries around the world were on the classical gold standard. This money system was different from the money system as it prevails today.

At present, the currency that we use is basically fiat money. It is money because the government says so. This money is not backed by gold or any other commodity.

But before 1913, every currency unit was worth a certain amount of gold, and it could be exchanged for gold.

When World War-I started many countries suspended the gold standard to be able to print enough money to be able to finance the war. The gold standard did not allow them to print money simply because when the printed money was spent people could turn up at banks demanding it be converted into gold. Given this, banks and governments could soon run out of gold.

Once WW-I ended, governments tried to go back to the gold standard. But a country like Germany, which was on the losing side, was financially in a bad state, and at the end of the war had a budget deficit of 11,300 million Deutsche marks. Budget deficit is the difference between what a government earns and what it spends.

What happened next?

As the government did not earn enough revenue to meet its expenditure it started to print money to finance the expenditure. In 1922, a trillion Deutsche marks were printed as the deficit shot through the roof. In the first six months of 1923, nearly 17 trillion Deutsche marks were printed.

With such an astonishing amount of money being printed, German money started to lose value dramatically. By August 1923, one dollar was worth 620,000 Deutsche marks and by early November it was worth 620 billion Deutsche marks. The price of essential commodities skyrocketed.

The industry, which thrived during this period was the money-printing industry.

Altogether, 30 paper mills and 133 printing plants were working, but still could not print enough money required to keep up with the amount needed.

On October 23, 1923, a statement issued by the German central bank said it had been able to print only 120 quadrillion (120 followed by 15 zeros) paper marks, when the demand had been a quintillion (one followed by 18 zeros). Inflation in Germany, at its peak, touched 1,000 million per cent.

How did it impact German society?

Practically all money had become worthless. A wheelbarrow full of money was not good enough to buy a newspaper. Walter Levy, a well-respected German-born oil consultant working in New York, would later recall that his father had taken out an insurance policy in 1903. He had religiously paid the premiums on the 20-year policy. When the policy had matured in 1923, the money he received was just enough to buy a loaf of bread.

As money lost value, barter came into the scene. Farmers who were not in dire need of money chose not to sell their produce to the townsmen. All in all, it was one big mess. As the money was losing value at a rapid rate men and women ran to spend their wages as soon as they were paid. Businesses had to employ people to count money.

In the end, the paper money had depreciated so much that it was simply used as wallpaper or even used as fuel to generate heat.

Germany decided to move to a new currency and called it the Renten mark. One Renten mark was deemed to be worth one trillion Reichs mark. Soon prices stabilised and the hyperinflation came to an end.

The rise of Hitler and WW-II

The German citizens lost their faith in the politicians and the political system of the day as they saw their lifetime savings fall to zero. Unionised unemployment rose to 30 per cent in 1923, from under 1 per cent in the previous year. People began to feel a sense of hatred and a loss of faith in the politicians of the day and in the German democratic system.

This paved the way for the rise of Adolf Hitler. As Henry Hazlitt, an American journalist, wrote in What You Should Know About Inflation: “It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.”

Hitler led Germany into WW-II, which started in 1939 and lasted until 1945. By the time WW-II was about to end, the global financial system was again in tatters. The financial system that emerged after WW-II had the American dollar at the heart of it. And the greenback was the only currency that could be converted into gold, but only by central banks of other countries.

What this meant was currencies of other countries were not backed by anything and governments could print money, as and when they wanted to. The final link between the dollar and gold broke down on August 15, 1971. This set the way for the Great American inflation of the 1970s and early 1980s.

The guns and butter policy

In the 1960s, the US was running a budget deficit. This was primarily because of the ‘guns and butter’ budgets that were being run by the American politicians of the day. The word ‘gun’ was in reference to the war that the US was fighting in Vietnam, and the word ‘butter’ was in reference to social programmes designed to achieve very low unemployment and redistribution of income.

This continued in the 1970s. The fact that the link with gold had broken down allowed the American government to flood the world with more and more dollars. This ultimately led to high inflation. Of course, what happened in the US, was nothing in comparison to the German hyperinflation of 1923. Inflation peaked in March 1980 at 14.8 per cent. While this might not sound anything as bad as what had happened in Germany, nonetheless, this was the highest inflation had ever been in the US since the late 1940s.

Paul Volcker took over as the Chairman of the US Federal Reserve, the American central bank, in August 1979. Determined to bring down inflation, Volcker started raising interest rates. By May 1981, the federal funds rate, a key short-term interest rate used by the Federal Reserve to carry out its monetary policy, was increased to more than 19 per cent.

Inflation under control

As Christopher Leonard writes in The Lords of Easy Money regarding Volcker: “[He] was willing to push the unemployment rate to 10 per cent to do so, to force homeowners to take out mortgages that carried 17 per cent interest rates or higher, and to make consumer loans so expensive that many Americans couldn’t afford to buy cars.”

The idea was to make money more expensive, in the hope of bringing down consumer demand. When that happened, less money would chase the same set of goods and services, leading to the rate of price rise or inflation coming down. This is precisely what happened with inflation falling to around 2.5 per cent by mid 1983.

So, what’s the lesson that we can draw from these two inflations? As Milton Friedman wrote in Money Mischief – Episodes in Monetary History: “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation… Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.”

To put it simply, high inflation occurs when the quantity of money chasing the same set of goods and services, goes up quickly.

What can we learn from this?

When the Covid-19 pandemic broke out in early 2020, the central banks of developed economies started to print money. The idea was to flood the financial system with money and help the governments, firms and individuals, borrow at lower interest rates. This would push up economic activity and, in the process, help prevent an economic depression. One estimate suggests that money worth close to $10 trillion was printed by different central banks.

A good portion of this money was indirectly handed over to the governments. In turn, the governments deposited this money directly into the bank accounts of people. Generous unemployment allowances were also given through much of the Western world. This sent the demand for things soaring. At the same time, global supply chains broke down. The world ended up in a situation where too much money was chasing a lesser number of goods, pushing up prices in the process, leading to high inflation.

While this happened, the central banks of the rich world were caught napping, primarily because much of the rich world hadn’t seen high inflation for a while. Now they are trying to rein in high inflation by pushing up interest rates and by also gradually taking out some of the money that they have printed and pumped into the financial system.

They have come to the realisation that the prevailing inflation is a monetary phenomenon. Of course, in the process they run the risk of pushing interest rates high and engineering an economic recession. And that’s how things stand as of now.

As the philosopher George Santanya once said: “Those who cannot remember the past are condemned to repeat it.”

Vivek Kaul is the author of the Easy Money Trilogy