resilience, not stability

Hyperinflation, Deficits and Real Interest Rates

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Hyperinflation is often viewed as a phenomenon where a currency is repudiated by its holders who refuse to hold the currency in any nominal form i.e. a collapse in demand for the currency. This is a reasonable but nevertheless incomplete explanation of how hyperinflation plays out in reality in modern capitalist economies.

In a world of interest-bearing money, high and monetised fiscal deficits by themselves are not reason enough for deposit-holders to repudiate a currency. If the central bank maintains a nominal interest rate at the short-end that compensates money-holders for the fiscally-created inflation, then there is no shortage of willing holders for the currency (in an interest-bearing form such as deposits). By the same token, the central bank must adjust lending rates at the short end (the equivalent of the ECB repo rate) to avoid an explosion in private credit growth fuelled by negative real rates. For each chosen fiscal regime, there is a monetary stance that can avert hyperinflation. However as fiscal deficits increase beyond a point, the equilibrating monetary stance consists of a nominal lending rate that must necessarily crowd out the private economy.

Understandably, most central banks are reluctant to raise rates in such a dramatic fashion. Instead they raise rates but only to the extent that real rates remain negative but not negative enough to motivate a wholesale repudiation of the currency. So long as real rates are maintained at a small negative rate, deposit-holders usually treat it as a “safe asset” premium that they are willing to pay. An environment that enables hyperinflation as a possibility is triggered when these real rates turn significantly negative. Significant negative real rates encourage holders of the currency even in its interest-bearing deposit form to shed their holdings of the currency when faced with constant and high real losses, losses that cannot be justified simply on account of the safety premium of the nominal asset.

But this repudiation of money is not the core driver of hyperinflation as we know it in the modern world. What almost always accompanies this repudiation is a sustained barrage of borrowing at the artificially low nominal and real rate enforced by the central bank or government (directly or indirectly via banks). Until late in the Weimar inflation, the Reichsbank kept discount rates as low as 5% (see table here) , a free lunch that was taken full advantage of by bankers and industrialists to lever up and invest in any real assets they could find. As Adam Fergusson notes, “new borrowings from the Reichsbank…from whom commercial enterprises could obtain credit at very low discount rates even at the height of the crisis in 1923, were automatically written off” due to the ludicrously negative levels of real interest rates that were enabled by the Reichsbank. The same was true in Zimbabwe where the central bank not only maintained one-year treasury bill rates at a level well below the inflation rate (enabling monetisation of deficits at a subsidised rate) but did the same with prime and bank lending rates which led to the predictable explosion in private sector credit expansion (see data here for a sample month).

Once real rates become sufficiently negative, credit growth explodes and the positive feedback loop of ever higher inflation fuelled not just by currency repudiation but by active exploitation of the banking and central bank discount window to access essentially free loans is set in motion. In other words, hyperinflation in modern capitalist economies is characterised not just by a collapse in the demand for deposits but an explosion in demand for loans at the “free lunch” level of nominal interest rates enforced by the central bank. Many commentators have recently asserted that Iran is in the midst of hyperinflation. Whether this is actually the case is still unclear – the current bout of higher inflation and prices may yet turn out to be temporary. But what makes hyperinflation possible is clear. Both lending rates and deposit rates have been set at levels well below the inflation rate for years now, a situation that threatens to descend into farce with inflation at above 50% per month and bank rates at only 21% per annum.

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Written by Ashwin Parameswaran

October 12th, 2012 at 3:32 pm

Posted in Monetary Policy

13 Responses to 'Hyperinflation, Deficits and Real Interest Rates'

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  1. Ashwin,
    Many seem to think that wealthy creditors abhor high inflation as it erodes the value of their fixed-income securities. Your post is a good example of why this isn’t true. Both wealthy households and financial institutions borrow at negative real rates to speculate on real asset inflation. Un-hedged, un-unionized, and un-sophisticated middle class wage earners and seniors are left to pay the inflation tax. The result, as happened in Latin America, is stagnant real wages and increasing income inequality.

    Diego Espinosa

    12 Oct 12 at 6:43 pm

  2. Diego – absolutely. Same was true in Weimar Germany – most of the rich and wealthy did brilliantly by gaming the discount window via their industrial interests. There is anecdotal evidence that the same is true for Iran today.


    12 Oct 12 at 7:00 pm

  3. Well said.


    12 Oct 12 at 7:22 pm

  4. If you are correct, this means that a hyperinflation can be avoided by high property taxes, because this eliminates the “free lunch”-option … high property taxes, of course, bear some resemblance to hyperinflation, but my be more “fair”. Everyone is taxed the same based on their property, not home owners preferred to fixed income assets.


    21 Oct 12 at 4:27 pm

  5. Stefan – The rate of taxation would have to be incredibly high to make a dent. Much easier for the central bank to simply end the regime of negative real rates.


    22 Oct 12 at 12:04 pm

  6. Ashwin, I took your name in vain (again) in a post today. You can find it at my website or here:

    Thanks and regards.



    1 Nov 12 at 1:26 pm

  7. Nothing in your article suggests the lending is the cause of hyperinflation. It merely could be an effect. For private entities to have such negative rates that they could be written off relatively soon would suggest already a very high rate of inflation since rates were kept at 5%. Could be that the hyperinflation was already in its early stages and the steepening neg rates were symptoms of later stages of hyperinflation. Since new money is printed, the first two people to get their hands on the money is government and banks so it is not out of the ordinary to think that they would have the choicest loans during a hyperinflation.

    blah blah blah

    8 Nov 12 at 12:51 pm

  8. There’s a difference between high inflation and hyperinflation. High double-digit inflation is a routine occurrence in many developing countries and entirely sustainable as long as the central bank keeps rates high enough to avoid excessively negative real rates. In each of the above instances, hyperinflation could have been avoided if the CB had simply hiked rates dramatically in what you call the “early stage”. It is their refusal to do so that triggered the hyperinflation which I define as the process where the money essentially loses all value in a short period of time.


    8 Nov 12 at 3:04 pm

  9. In order for monetary policy to be a credible anti-inflation weapon, the CB has to basically be determined to ‘destroy output’. In the case of hyperinflation episodes, the starting point is actually a large output shock, which makes the idea of even more output loss a bit questionable.

    What is needed is output stabilization. Unless that can be achieved, I think that the only options are hyperinflation or deflation.

    Are you aware of any hyperinflation episodes which were not matched by large output shocks (which usually happen first)?

    Kostas Kalevras

    24 Nov 12 at 1:10 pm

  10. Kostas – large output shocks that are supply-side shocks shouldn’t be tackled via demand-side stimulus.

    On the historical evidence, it’s honestly hard to say what the ultimate causes of the various episodes are. My only point is that a combination of fiscal contraction and/or monetary tightening can always prevent hyperinflation whatever the trigger tends to be.


    24 Nov 12 at 1:29 pm

  11. Ashwin,

    “large output shocks that are supply-side shocks shouldn’t be tackled via demand-side stimulus.”

    When I wrote ‘output stabilization’ I was mainly referring to the fact that in order to combat hyperinflation what is needed in the first place is for output to return to ‘normal’. Factories to reopen in the Ruhr, farm output to stabilize in Zimbabwe.

    “My only point is that a combination of fiscal contraction and/or monetary tightening can always prevent hyperinflation whatever the trigger tends to be.”

    My fear is that combating hyperinflation (when its cause is a large fall in output) is destined to lead to deflation and depression not to a return to a low and stable inflation regime.

    Consider a scenario where inflation is 100% while the interbank rate is 10%. If financial assets were bearing coupons of 12% it is true that the inflation-adjusted return-on-capital of a dealer purchasing these using borrowed funds (say in the repo market or using the CB discount window) would be very low unless he increased its purchases substantially. But his capital would remain intact.

    A commitment by the CB to fight this inflation wave by raising rates is basically a commitment to inflict large capital losses on any (financial and real) asset holder who finances his portfolio through short-term borrowing. This action would lead to actual loss of capital and bankruptcies. It would be highly deflationary and create large stress in the markets by increasing the actual risk of principal loss on loans. In the end it would be even more destabilizing than a large inflation wave and threaten the very existence of the financial market as well as lead to a serious loss of output.

    If we ‘re talking about a supply-shock on output (even one that leads to hyperinflation) is monetary policy the right tool? If Israel bombed Iran to the ground and oil went to 300$/barrel would it be a good idea to use interest rates to combat the resulting inflation?

    I think it’s rather different to attack an inflation wave (however large it might) than to try to move the long-run inflation expectations (something that Volcker did in 1980 for instance).

    Kostas Kalevras

    24 Nov 12 at 4:58 pm

  12. Kostas – when inflation is 10% and inflation is 100%, no securities are trading at 12% yield. Private firms/banks borrow at 10% and buy real assets i.e. the ones going up an average of 100% a year. There is no incentive for anyone to invest in a 12% yield asset.

    Hiking rates simply stops this taxpayer-funded transfer of the country’s wealth to those who have access to the central bank.

    Even a short period of such negative real rates essentially wipes out all debts – private or public. There is no possibility of a debt-deflation cycle in such an environment. When rates are hiked and/or fiscal spending is slashed, the economy usually does just fine – the post-Weimar experience is a good example.


    26 Nov 12 at 11:43 pm

  13. Ashwin

    We are talking about long-term securities and a wave of inflation. How their yields will react will depend on if the private sector considers the inflation permanent and how the central bank will react (which is our question anyway) since its the one that sets the cost of funds for the economy. For a dual mandate CB (such as the Fed), the reaction is not that clear.

    In any case, what I am trying to say is that the CB ‘reaction function’ is not symmetrical. In a falling inflation environment (not negative inflation), falling interest rates provide capital gains to holders of long-term securities. When interest rates are hiked (in a unexpected manner), the CB is commiting to inflict capital losses on holders of long-term securities.

    At some point, interest rates hikes and the financial stability mandate start conflicting each other. No CB would be allowed to fight hyperinflation by destroying the financial sector which means that, after a certain dose of inflation, its actions happen with a lag.

    Kostas Kalevras

    27 Nov 12 at 7:40 am

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