Wednesday, March 25, 2009

Differences In Hyperinflation: Germany vs. Zimbabwe

(1) The origins of hyperinflation

The outbreak of hyperinflation in Weimar Republic in 1920s actually had its roots since World War I. The Germans had borrowed a large sum of money to finance the war. When the supply of funds proved inadequate, the Central Bank, Reischbank have no choice but to print more money to finance itself. The currency that time was not backed by anything, given the collapsed of gold standard in 1914. Therefore there was no limit on the amount of money that can be printed

There were 2 hypotheses built around the cause of hyperinflation in Zimbabwe. Firstly, critics argued that it originated from Mugabe’s controversial land reform policy. Lands were confiscated from the White farmers, further break down & ‘so said’ equitably distributed to landless peasants, when the primary beneficiaries are ministers & their nearest families. Having no experience at all in dealing with modern faming, farm’s productivity suffered a freefall. Exports revenue was jeopardised, giving them a hard time to settle their debt with IMF. As a last resort, they start to print more money

Secondly, the supporters of Mugabe argued that economic collapse is as a result of international sanctions by US, EU & Australia which target several ministers & companies loyal to Mugabe’s regime like ZDERA. As a result, foreign capital stops flowing in & Zimbabwean government will have to print money to buy foreign currency to settle its debt with IMF

(2) What makes it worse after that?

The new Social Democratic government after the war had an ambitious plan to improve the life of the poor in Germany. They were just too expensive to deliver. As such, more monies were borrowed & more currency was printed. At the same time, hyperinflation was worsened with the demand of reparations by the Allies, to compensate for all the damages done to their economies e.g. destruction of infrastructures & buildings. This forced Germany to print even more money Later years, the Germans decided to stop paying the reparations. In response the French & Belgian troops occupied Ruhr in 1923, the more industrialised area. They intended to get reparations in the form of goods & raw materials. The government ordered workers to stop working as a mean of boycotting. As governments had not much money to pay them, the only option is again-print more money

Source: economicshelp

Hyperinflation in this case can be easily explained using the quantity theory of money & AD-AS diagram. Hyperinflation happens when there is an imbalance, when the increase in the amount of money is not matched by the increase in output as in above case. Too much money is chasing too few goods, bidding up their prices. From AD-AS analysis above, it can be seen that rapid increase in spending when there is no increase in real output will cause an economy ending up with higher inflationary pressure

Source: sparknotes

Although having a different cause, its aftermath is the same. Zimbabwean government placed the blame onto businesses for recklessly raising the price of their goods. So they attempted to distort the working of the market via price intervention. In February 2007, central bank of Zimbabwe declared inflation as ‘illegal’. Prices of goods were capped (refer diagram above). Those which raised the price were arrested. From economics point of view, imposition of ceiling price further discouraged production. This was the starting point to worsening hyperinflation. More monies were printed & yet there is a bottleneck in supply of output (refer to AD-AS diagram)

(3) Solutions

In 1923, the German government issued a new currency called Rentenmark, which was backed by land & property. Each Rentenmark was exchangeable for 1 trillion old marks. This had successfully created confidence among the people. First, when the new currency was tied to something, it limits the amount of money that can be printed. So this was somewhat the new ‘gold standard’ around that time. Secondly, lesser zeros actually created a ‘psychological effect’ telling the people that things are cheaper. For instance, an item with the price of 4 trillion old marks (12 zeros) was available with 4 Rentenmark

Once people had faith with the currency, they will stop rushing to stores to purchase goods as they believed that the currency will no longer lose its value rapidly. To ease problems further, government expenditures were cut & more than 700, 000 public sectors employees were sacked. Having confidence with the new macroeconomic management, US & some European countries began to offer aid. Germans received loans of 800 million gold marks & therefore they issue a new currency called Reischmark which was then backed by gold. It was equivalent in value with Rentenmark. Amazingly, German government ran into surplus in 1925!

In the recent, there was an interesting development on solutions to hyperinflation in Rhodesia. Prices of essentials like cereals & breads had gone down for the first time. It seems that there could be a possibility of abandoning the Zimbabwean dollar which was increasingly worthless. A trillion Zimbabwean dollars now can’t even buy a loaf of bread. There is also talk rifling, either the adoption of South African rand or the American dollar into their economy, although the impact is very much subjected to debate. Nevertheless, it is still too early to tell. The newly formed government is still a lose-coalition. Anything can happen later!

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