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How Zimbabwe lost control of inflation
Gilbert Muponda, New Zimbabwe
January 09, 2008

http://www.newzimbabwe.com/pages/inflation180.17386.html

Zimbabwe's chart topping inflation reportedly at 24,000 % qualifies the nation as experiencing hyper inflation. Compare that to the next highest inflation of 40% in Burma.

The main cause of hyperinflation is a massive and rapid increase in the amount of money (estimated at 17,000%), which is not supported by growth in the output of goods and services.

This results in an imbalance between the supply and demand for the money (including currency and bank deposits), accompanied by a complete loss of confidence in the money, similar to a bank run.

The enactment of legal tender laws and price controls to prevent discounting the value of paper money relative to gold, silver, hard currency, or commodities, fails to force acceptance of paper money which lacks intrinsic value.

When the entity responsible for printing a currency promotes excessive money printing, with other factors contributing a reinforcing effect, hyperinflation usually continues.

The body responsible for printing the currency cannot physically print paper currency faster than the rate at which it is devaluing, thus neutralising their attempts to stimulate the economy. This is clear with the new $750,000 bearer (or is it burial) cheque. The country-s highest note cannot even buy a loaf of bread. Can you imagine walking into Tesco in the UK and one loaf costing more than £50, or being in Walmart in the USA, and a loaf going for more than US$100? Imagine being in No Frills, in Canada one loaf going for more than C$100? This is how Zimbabwe-s currency has been absurdly decimated by inflation.

Zimbabwe-s hyper-Inflation is a result of the monetary authority irresponsibly borrowing money to pay all its expenses and funding quasi-fiscal activities (which are normally left to Central Government). In Neoliberalism, hyperinflation is considered to be the result of a crisis of confidence. The monetary base of the country flees, producing widespread fear that individuals will not be able to convert local currency to some more transportable form, such as gold or an internationally recognised hard currency.

In neo-classical economic theory, hyperinflation is rooted in a deterioration of the monetary base; that is the confidence that there is a store of value which the currency will be able to command later. The perceived risk of holding currency rises dramatically, and sellers demand increasingly high premiums to accept the currency. This in turn leads to a greater fear that the currency will collapse, causing even higher premiums. This is akin to trading cash with no apparent economic activity (read Cash Baron)!

Rates of inflation of several hundred percent per month are often seen. Extreme examples include:

• Germany in 1923 when the rate of inflation hit 3.25 × 106 percent per month (prices double every 49 hours).
• Greece during its occupation by German troops (1941-1944) with 8.55 × 109 percent per month (prices double every 28 hours).
• The most severe known incident of inflation was in Hungary after the end of World War II at 4.19 × 1016 percent per month (prices double every 15 hours).
• More recently, Yugoslavia suffered 5 × 1015 percent inflation per month (prices double every 16 hours) between October 1, 1993 and January 24, 1994. Zimbabwe may be on its path to match if not break some of these records.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. A small amount of inflation is generally viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment.

Efforts to attain complete price stability can also lead to deflation, which is generally viewed as a negative because of the downward adjustments in wages and output that are associated with it. More generally, because modest inflation means that the price of any given good is likely to increase over time, there is an inherent advantage to making purchases sooner than later. This effect tends to keep an economy active in the short term by encouraging spending and borrowing, and in the long term by encouraging investments.

High inflation, though, tends to reduce long-term capital formation by hurting the incentive to save, and to effectively reduce long-term spending by making products less affordable. Limited investments will result in shortages of opportunities for corporates which will be forced into speculation. In addition, corporates become less focused on core-business as they try to survive. This can lead to corporate cannibalisation whereby companies essentially trade each other-s shares without any meaningful investment in plant, equipment, stock or capacity.

Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation. In investing, inflation risks often cause investors to take on a more systematic risk, in order to gain returns that will stay ahead of expected inflation. Inflation is also used as an index for cost of living adjustments and as a peg for some bonds. In effect, inflation is the rate at which previous economic transactions are discounted economically.

However, in general, inflation rates above the nominal amounts required to give monetary freedom, and investing incentive, are regarded as negative, particularly because in current economic theory, inflation begets further inflationary expectations. Increasing uncertainty may discourage investment and saving.

Redistribution: Inflation will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation -- any senior pensioner still receiving a couple of thousand Zimbabwe dollars being a clear example. Similarly, it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, inflation will reduce this debt by redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax. This discourages savings and investment, the actual tax regime becomes impossible to calculate.

International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade, and forex shortage will set in.

Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank or hours spend trying to access cash). Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.

Some economists see moderate inflation as a benefit; some business executives see mild inflation as "greasing the wheels of commerce."

Demand-pull inflation: Inflation caused by increases in aggregate demand due to increased private and government spending, etc.

Cost-push inflation: Presently termed "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Unavailability of forex being a key driver of cost push inflation in Zimbabwe.

Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation. All these factors are now at play in Zimbabwe, its now impossible to separate what is causing what.

The 'Rational Expectations Theory- holds that economic actors look rationally into the future when trying to maximise their well-being, and do not respond solely to immediate opportunity costs and pressures.

A core assertion of rational expectations theory is that market participants will seek to "head off" central-bank decisions by acting in ways that fulfil predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession. But when you promise to withdraw a high value note only to say "I was just joking", that won-t do much to build a solid reputation.

There are a number of methods that have been suggested to control inflation. Central banks such as the Reserve Bank of Zimbabwe can affect inflation to a significant extent through setting interest rates and through open market operations (that is, using monetary policy).

In Zimbabwe, however, monetary policy has ceased to be a useful management tool. The inflation is at 24 000 %, the RBZ borrows through treasury bills at 340% then on-lends the money at 25% .This sequence of rates is a disaster. If monetary policy was to be an effective tool, using the above numbers, the RBZ would have to borrow at slightly above 24000%, then on-lend at even higher rate say 24 050%.

High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied. Facilities such as Baccossi are highly inflationary. Such facilities subsidise loans and eliminate commercial banking activity since corporates are driven to borrow from such facilities and get a false sense of efficiency.

Wage and price controls have been successful in wartime environments. In general, wage and price controls are regarded as a drastic measure, and only effective when coupled with policies designed to reduce the underlying causes of inflation during the control regime, for example, winning the war (in Zimbabwe-s case winning the 4th Chimurenga).

The usual economic analysis is that which is under-priced is over-consumed, and that the distortions that occur will force adjustments in supply. For example, if the official price of bread is too low, there will be too little bread at official prices. And your only source of bread becomes the black market. This trend undermines the formal sector as more activity goes underground and the government-s ability to raise revenue is reduced.

The removal of zeros only works if accompanied by an influx of forex to support the local currency. This can be in form of foreign aid, foreign direct investment or increased exports.

Temporary controls may complement a recession as a way to fight inflation. That is to say the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kind of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalise prices by assuming that the economy will adjust and abandon unprofitable economic activity.

The lower activity will place fewer demands on whatever commodities were driving inflation, whether labour or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed.

Price controls such as "Operation Dzikisa Mutengo", whilst initially very popular, they can ruin a nation dramatically fast.

Gilbert Muponda is a Zimbabwe-born entrepreneur, living in exile. He can be contacted at gilbert@gilbertmuponda.com

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