Why inflation happens to an economy is a phenomenon that is often discussed in the public discourses but very little is said about hyperinflation This happens perhaps because the latter is a scarier thing and it has not happened to us yet even though we came close to it in the Nineteen Seventies. But hyperinflation is nothing more than a galloping inflation that gets out of hand and goes high in a short period of time. It can happen to anyone so let us look at the subject from a fresh angle.
People toss around the saying: “All money is borrowed money” without thinking much what it means yet the reality is that the saying describes how an economy works. The trouble is that it is impossible to give much detail while discussing a large and modern economy. Thus, a better approach would be to imagine an island populated by say, 10,000 people who live in a simple, almost primitive economy. However, these people will have to be modern because, when all is said and done, their activities will have parodied a modern economy.
The island has a central bank where every morning business people go to borrow the money they will need for the day. They hire people to work for them and pay wages and salaries with the borrowed money. They also pay themselves what they call profit. At the end of the day, wealth will have been created in the form of food to eat, clothes to wear, homes to shelter from the elements, furniture for the homes, agricultural implements, and a host of services such as education, medical care, entertainment and so on.
Before heading home at the end of the day, the workers use all the money they receive; and the business people use all the profit they make to buy the products and services that were produced in that day. In theory, every business that borrowed money should have the same amount come back to it at the end of the day, and the money is then returned to the bank.
The next day the people of the island go through the cycle again in that they borrow the money, create the wealth and return the money to the bank. Some of the wealth they create will be non durable goods and they will consume it in a relatively short period of time; some will be durable goods and they will keep using it for two years or longer.
Let us now ask a simple question: What happens if a businessman borrowed money to make pottery but an accident occurs and the pottery is destroyed after he pays the workers but before he delivers the goods to his clients? The answer is that he will have no money to return to the bank because the money will now be in circulation where it will remain for ever.
But a new situation will have been created where the total amount of goods and services on the island has diminished by a value equal to the price of the pottery. And because at the end of the day all the available money will be spent on buying all the remaining goods and services, prices will rise across the board. This is inflation.
Stripped to its essence, this is how an economy that is based on paper money works. But of course things will be more complicated in a real economy even on that primitive island. To begin with, not every undertaking can be started and finished the same day, therefore workers and business people will have to keep some of the money for more than a day. Because of this reason and a few other ones, the principle of paying interest on borrowed money will have to be introduced.
There is also the fact that in a large economy the central bank cannot deal directly with all the business people who will want to use its services. Thus, another industry called financial services will have to be added to the sector. It will comprise the commercial or chartered banks and the other lending institutions which will stand as “middleman” between the central bank on one hand and the public and business people on the other. These institutions will borrow money at a certain rate of interest from the central bank and lend it at a higher rate to their clients.
The institutions will also accept deposits from their clients. At the end of the day each branch may show a surplus or a deficit, or it may break even in the sense that it will have lent as much money as came to it in the form of deposits. By law the banks that show a deficit must borrow overnight money from another bank that happens to have a surplus or from the lender of last resort which is the central bank. In this, the modern operation of a bank mimics what we had on the island when the money was returned to the central bank at the end of each day.
Still, there is a difference between the two in the sense that we now have a set up that will be conducive to unleashing the forces of hyperinflation. The reasons why this can happen are many, so let me discuss a few.
First, when you have a large and complex economy you need a government of civil servants to run the country. You also have large pools of workers in the same profession who may be members of the same union. If as a result of a persistent inflation the civil servants or one of the unions demand and receive an increase in salary, they may trigger a vicious cycle.
This will happen because an increase in wages for one party will aggravate the inflation which may prompt another party to demand a pay hike which will further aggravate the inflation and prompt still another party to demand a pay hike and so on. A galloping inflation may result and get out of hand to become a hyperinflation.
Second, because there is a relationship between growth of the money supply and growth in the size of the economy, a persistent inflation can lead to shortages in the labor market or the commodities market. By the law of supply and demand, this too can lead to a galloping inflation and the eventual hyperinflation.
Third, when a lending institution becomes too greedy, it borrows from the central bank and lends more than it should thus increasing the money supply more than is warranted. While this will look healthy in the short run in that it will stimulate the economy, it may start a bubble that feeds on itself and grow to a dangerous level. This is triggered when the other lending institutions jump into the act for fear of being left behind and do the same thing.
Eventually the bubble will burst and the institutions will be left holding IOUs whose real value will be close to worthless. They will cease to lend to each other fearing they may never get their money back and will curtail their lending to the public as a result. This situation creates a credit crunch in an economy whose lifeblood is credit.
To ease the problem, the central bank will swap the dubious loan portfolios at the lending institutions with cash or with the near excellent securities it keeps in its own vault. The justification the bank will give for doing this is that the measure will be temporary, meant to last only until the institutions get back on their feet at which time the swaps will be reversed.
But if the situation with the credit crunch is not reversed soon enough and the institutions start to go belly up, the money will never be returned to the central bank. In this case, we shall have a situation analogous to the pottery accident on the island when the money was not returned to the bank but remain in circulation for ever. The situation will also be akin to the printing of money such as it happened in a number of countries since the invention of paper money.
And this, in my opinion, can be the trigger to ignite a wild inflation and gallop to become a hyperinflation. How to avoid it is the subject of the next article.