Setting the Stage: Hyperinflation Throughout History
Look at this. It's Germany in 1923. People were using banknotes to wallpaper their houses, even to start fires. The German mark became worthless, not even suitable for toilet paper. Prices were doubling every two days on average. The annual inflation rate reached…
Now, let's move on to Zimbabwe in 2008. They printed that infamous banknote. Look, you can't even count all the zeros. It's 100 trillion Zimbabwean dollars! Prices were doubling every 24.7 hours on average. The annual inflation rate reached… Seven point three times ten to the power of… guess how much… 108! I have no idea what that even means.
And this is Hungary in 1946. Prices were doubling every 15.6 hours on average. The annual inflation rate…
We might take these historical events as jokes now, but for the economies at that time, they were catastrophic.
In 2022, the sudden surge of inflation in the US, EU, and UK once again brought this term to the forefront of the global economy. I've discussed this topic many times before, and today, I'll help you fully understand it. We'll try to keep it light and interesting while delving deep into inflation, and what governments and central banks are thinking.
Are you ready?
Demystifying Inflation
"Inflation" refers to the devaluation of currency. The most common indicator we use to measure it is called CPI, the Consumer Price Index. It essentially measures the price trends of the goods and services we use daily.
Look at the US CPI. Sixty years ago, it was around 29.9. Now it's 296. This absolute number doesn't mean much by itself. But if you compare them, you'll understand that current US prices are roughly ten times higher than they were sixty years ago. In other words, one dollar sixty years ago is roughly equivalent to ten dollars today. Isn't it lower than the inflation rate you imagined?
Looking at the inflation effect in other countries over the same sixty years, we see prices in Australia have increased sixteenfold, twenty-fivefold in the UK, eighty-eightfold in India, and a staggering 9.7 million times in Turkey.
Rising prices mean money is becoming less valuable. This is easy to understand. However, if we want to understand inflation in depth, we first need to look at a formula…
Just kidding! How could I talk about such a boring formula?
Actually, economists use a plethora of formulas to describe and explain inflation. Keynesianism, monetarism, New Keynesianism, blah blah blah… They all seem to make sense, but almost none of them work well in the long run. This is what makes inflation so fascinating. Its causes are incredibly simple: it's nothing more than the amount of currency circulating in the economy exceeding the economy's capacity. Too much money chasing too few goods will inevitably lead to price increases.
But as simple as this sounds, it's challenging to control. You see, the primary, and often the only, goal of central banks around the world is to maintain price stability. Print as much money as you want, adjust interest rates as you please, just make sure to keep prices stable, keep inflation under control. But they just can't seem to get it right. Even institutions like the Federal Reserve and the European Central Bank, filled with the world's top economists, often disagree internally. This is clearly not that simple.
Let's elevate our thinking. From the perspective of the entire economy, money is merely a tool for circulation. Therefore, the purchasing power represented by this currency, for example, whether this cup of milk tea costs 3 yuan or 300 yuan, doesn't really matter. What we are truly pursuing is…well, more happiness, more joy, more… We won't discuss such lofty ideals today.
For an economy, what we are pursuing is actually higher output value. To put it simply, higher GDP. This means everyone works hard, diligently produces, to create more and better products and services. Then, as consumers, we can consume and enjoy these improved products and services. This way, the entire economy operates more efficiently. This is what we strive for.
From a monetary perspective, how can we achieve higher output value? Our natural inclination is to think that since currency is just a medium of exchange in the economy, we should aim for stability. In other words, if you have 100 yuan, you should always be able to buy the same amount of goods with it. Stable. This would help the economy run smoothly.
However, people gradually realized that if the money in our hands isn't completely constant, but is slowly depreciating for everyone, then even if you hide a box of money under your bed, seemingly safe and sound, its purchasing power will gradually diminish due to inflation. This purchasing power is then transferred to the newly created money. Essentially, it's a continuous, subtle adjustment of everyone's wealth. It's like saying, "I can't let you get too comfortable. I have to make sure you don't just hoard money under your bed, but instead force you to earn, to produce, to consume."
In other words, inflation is a constant redistribution of wealth. Exciting, isn't it? For example, if a cup of milk tea costs 20 yuan this year, and next year the same cup costs 21 yuan, you'll realize that if you don't spend the money in your hand this year, it will be worth less next year. So you might as well spend more now. This will encourage more people to spend immediately, which increases aggregate social demand and thus GDP.
It's like stirring the still water with inflation to stimulate greater vitality. This is why it's widely believed that a moderate level of inflation is beneficial for the overall economy.
Of course, as consumers, we don't particularly enjoy this sense of urgency to spend. So, many people include inflation in what's called the "Misery Index." But generally speaking, economists don't really care about your misery index. Economic development is far more important.
Now, what if we reverse it and talk about deflation? It means that with the same 100 yuan, you can buy more goods next year than this year. Then I would definitely hoard my money under the bed. This way, my wealth effectively increases year after year. Doesn't that sound painless and enjoyable?
But the problem is, people will stop working hard and earning money. They'll just stay at home and relax. Spending will also be minimized. After all, not spending is essentially the same as earning money. Then everyone will adopt a "don't spend unless absolutely necessary" mentality. This, in the long run, will lead to a terrifying deflationary spiral.
Japan is a classic example. After the bubble burst in the 1990s, it fell into deflation. Then, credit evaporated, and even after 30 years, no matter how much the central bank stimulated or the government borrowed, demand simply wouldn't budge. Of course, they have a series of cultural and aging population issues. But you can see how terrifying deflation can be.
So, you see, increasingly cheaper prices are not the real problem. The real problem is that people stop working, stop striving, stop earning, stop producing, and lie flat, unwilling to spend. This leads to a low-desire society, which is the deeper issue.
Our concern with inflation stems not from the price changes themselves, but from the changes in demand and GDP brought about by those price changes. However, the wealth redistribution effect of inflation can't be too extreme either. For example, if the money under my bed can buy 100 cups of milk tea this year, 99 cups next year, and 98 cups the year after, you might think it's still manageable. I'll just work harder and earn more.
But if it's like Zimbabwe, where I can buy 100 cups of milk tea today, 50 cups tomorrow, and none next week, then what's the point of earning money? They're just resetting the game every other day, reshuffling everyone's wealth. Why bother working hard to support my family when everything gets reset? I might as well lie flat. If the money I earn is burning a hole in my pocket, I'll just spend it all immediately. Whatever's left will vanish anyway if I save it.
This situation is called hyperinflation. It's devastating to an economy. For example, in post-World War I Germany, a loaf of bread cost 100 billion marks. The next day, it could be 200 billion. In this situation, the economy's financial and credit systems are essentially paralyzed, and productivity plummets. Germany saw 6 million people unemployed within six months. This ultimately led to new currency and military controls, political turmoil, and indirectly contributed to Hitler's rise to power.
Throughout history, almost every country that has experienced hyperinflation had to undergo arduous, comprehensive reforms and restarts to slowly recover.
So you see, the deflation we mentioned earlier is like the economy freezing over, stagnating. Hyperinflation, on the other hand, is like the economy overheating and spontaneously combusting, burning more and more fiercely. Neither is desirable.
The Rationale Behind "Good" Inflation
We've discussed the horrors of deflation and hyperinflation. Now, can we delve deeper into why most economists advocate for moderate inflation? It's all about finding the right balance.
For instance, central banks in the US, Europe, UK, Japan, Canada, and Australia have set their inflation targets at around 2% to 3%. Most other central banks, while not necessarily announcing a specific inflation target, also aim to keep inflation between 2% and 5%.
Regardless of the monetary policies they employ, the primary objective of these central banks is to maintain inflation within a reasonable range. This remains true even if it means sacrificing some short-term economic growth or even entering a short-term recession. Controlling inflation is the bottom line for major developed economies today.
On a side note, some might wonder about the impact of inflation on asset prices, such as stocks and real estate. Theoretically, it's difficult to say for sure because there are many confounding factors. However, if you had to guess intuitively, you might assume a positive correlation. Since prices rise during inflation, people might invest in real estate or the stock market to hedge against it.
Interestingly, however, a study by the IMF on the relationship between stock prices and inflation in 71 economies showed… I won't go into the specifics of the chart, but the conclusion is that regardless of whether it's a developed or developing country, stock market performance and inflation are actually negatively correlated. In other words, during periods of high inflation, stocks generally decline.
This is primarily because the main driver of stock market declines is policy. During periods of high inflation, governments and central banks are likely to implement contractionary fiscal and monetary policies to curb inflation, leading to stock market declines. This is why Turkey is an exception. They didn't implement contractionary policies during their period of high inflation, resulting in their stock market tripling within a year.
Of course, there's another exception: energy company stocks. Historical data shows that they generally perform very well during periods of high inflation. This is also consistent with the global inflation trend in 2022. Remember we just awarded ExxonMobil for having the best performing stock?
Unpacking the Causes of Inflation
So, what exactly causes inflation? You might intuitively think it's because the central bank is printing money, or printing too much of it.
Well, it's not that straightforward. It's partially true, but not entirely. Sometimes, governments can trigger inflation without printing money. Other times, they can print endlessly without causing inflation. Just look at Japan, which experienced over two decades of unlimited money printing and still faced deflation.
Let's break down the causes of inflation. There are generally three main factors:
1. Demand-Pull Inflation
Imagine a normally functioning economy. Suddenly, for some reason, everyone craves milk tea. So, without any other changes, there's an additional demand in this economy. People rush to milk tea shops, and millions of milk tea shop owners across the country rejoice. This leads to two outcomes: they either produce more milk tea or increase prices. Regardless, the shop owners end up making more profit.
These profitable owners then use their earnings to buy food, bags, and other goods. The kinder ones might even give their employees bonuses or raises, who then use their extra income to buy more bags and food. This, in turn, boosts the sales of bags and food, entering another cycle of increased demand.
In summary, increased aggregate demand leads to higher output and prices, which in turn increases corporate profits, leading to higher consumption and further fueling demand growth. This creates a positive feedback loop. This is why we said earlier that increased aggregate demand leads to economic growth.
However, there's a side effect: rising prices, aka inflation. Therefore, the logic here is that demand-pull inflation occurs when demand outpaces supply.
Take Tesla, for example. What do they mean by "Let people buy it themselves?" It means the company is consistently profitable and wants to expand production to earn even more, to hire more people. However, the labor market is already nearing full employment. Doesn't this resemble the overcrowded milk tea shops we just discussed? What's the solution then? Raise prices! And there you have it, inflation.
Therefore, with the Federal Reserve continuing its quantitative easing in this environment, it's not surprising to see such high inflation.
Let's digress a little further. We mentioned earlier that printing money can stimulate demand, thereby entering the cycle of economic stimulus and inflation. However, central banks around the world are facing an awkward problem: they can't seem to get the money they print into circulation.
You see, the tools central banks use to control money supply are limited to adjusting interest rates or buying and selling financial assets. But in reality, these measures only keep the money circulating within the financial system.
For example, when the central bank buys a large amount of government and corporate bonds, the financial institutions that sell these bonds and receive the money are reluctant to withdraw or lend it to the real economy. They might even turn around and invest it in the stock market.
In other words, no matter how low the central bank lowers interest rates, commercial banks are unwilling to lend. This prevents the money from flowing into the real economy and reaching consumers like you and me, who would actually buy the milk tea.
Therefore, the central bank's efforts to cut interest rates and print money are in vain because the money never reaches the economic growth cycle we discussed. This partially explains why, for over a decade before 2020, despite massive quantitative easing and prolonged low interest rates in Japan, Europe, and the US, we didn't see inflation in the real economy, only a booming stock market.
After the pandemic hit, the Biden administration seemed to have figured it out. They realized that the central bank printing money wasn't effective anymore. The government had to step in and deliver the money directly to consumers.
In 2020, they sent out $1,200 to almost everyone, plus an additional $500 per child, $600 per month for the unemployed, and various loan forgiveness programs. In 2021, anyone earning less than $75,000 received another $1,400.
In short, they distributed around $5 trillion over those two years. To put it in perspective, it's equivalent to giving each American an average of $15,000.
2. Government Spending & Money Printing
Governments typically resort to unlimited money printing during times of war or due to political factors. They wouldn't resort to such a crude method of printing and spending their own money unless absolutely necessary. We all know the consequences; it's not like they're unaware.
Take the examples we mentioned earlier: Germany from 1920 to 1923 and Hungary from 1945 to 1946. They resorted to printing money out of desperation after suffering defeat in World War I and II and being burdened with massive reparations.
When the government prints money, the money supply increases, which stimulates demand and subsequently leads to demand-pull inflation. However, because the government prints excessively, inflation skyrockets. When it reaches a certain point, wealth redistribution accelerates, and people become content with simply meeting their basic needs, never considering saving.
However, this isn't true hyperinflation yet, only around 40% to 50%. At this point, even if the government recognizes the dangers of inflation and stops printing money, people have already reduced their work hours, leading to a decline in social productivity and a shortage of goods.
What happens next? Prices rise. This brings us to…
3. Cost-Push Inflation
This is inflation driven by supply shortages, not excessive demand.
As inflation continues to rise, people work even less, shortages worsen, and inflation spirals out of control. This is how we arrive at an astronomical inflation rate of 7.5 x 10^170.
Understanding these causes and their interplay is crucial for policymakers. So, if you aspire to work at a central bank someday, you might want to revisit this explanation a few times.