Not worth the paper it's printed on

A rich man died during the early days of the german Weimar Republic (so the story goes) and left all he had to his two sons. To the prudent one he willed his fortune, and to the profligate his collection of bottle caps. When the inflation came, the prudent son invested wisely and lost everything; the profligate sold the bottle caps and survived. Or, as Harvard economist Jeffrey Sachs says, hyperinflation (price increases of more than 50% in a single month) has "very costly, arbitrary distributive consequences."

When prices rise by more than 50% a month -- sometimes even doubling in four days -- they turn a nation's economy upside-down and render banknotes so much wastepaper. The same disaster that overtook Germany, Hungary and Russia in the 1920s and TK TK in the 1940s attacked Argentina, Bolivia, Colombia and TK in the 1980s. Brazil flirted with it earlier this year before a new economic stablization plan (the sixth in 10 years) took hold this summer. How does money so suddenly lose its value, and why are the effects so devastating?

It's all very simple, as Sachs explains it. First, a government gets in fiscal trouble and resorts to printing money to pay its bills. During the 1920s and 1940s national bankruptcy came on the heels of world wars; in the 1980's, it was the aftermath of excess international lending. This process does not increase the amount of goods available in the country, and so inflation counterbalances the excess currency. If the treasury doubles the supply of reichmarks or pengos or rubles, prices double. Each reichmark, pengo, or ruble is worth half of what it was, but the government's needs for gasoline, paper, bureaucrats, soldiers and so forth remain the same. So it prints more money to cover their now-inflated prices. Worse yet, citizens quickly realize that money is not a good investment. They seek to get rid of it, and so, as with any unwanted commodity, its value drops further. The spiral soon becomes vertiginous.

By itself, the falling value of money is not ruinous. A number of countries, most notably Brazil and Argentina, learned to deal with inflation rates of several hundred percent a year by indexing wages, pensions, savings accounts, loans and other financial objects to compensate for inflation. Just as auto workers or social security recipients in the U.S. received cost-of-living adjustments, the governments of high-inflation countries compensated their citizens. High and low rates of inflation are not qualitatively different, according to John Williamson of the Institute for International Economics -- perhaps adjustments have to be made on a monthly or weekly basis instead of an annual one, but the basic method is the same.

In theory, a perfectly-indexed economy could be almost indistinguishable from one with no inflation at all. The practice, of course, is unpleasantly different. If holding banknotes or uncashed checks for even a day means losing money, then financial transactions of all kinds become more difficult. "Finance is a grease for the economy," says Alan Gelb of the World Bank. "It's an intermediate input for production, the same way that a railway system is." And meddling destructively with money will hurt an economy "just as much as if you screw the rail system up," he asserts.

Furthermore, as Sachs notes, most countries do not come upon an episode of rampant inflation with indexing mechanisms in place. Hyperinflation strikes, he points out, when the government has lost its legitimacy and can no longer cut outlays or collect sufficient revenue to match ends and means. A nation emerging from the ruins of war or decades of totalitarian misrule is generally in no position to implement sophisticated financial controls, he says. And although the principles of hyperinflation may be rigidly mathematical, its implementation depends on the psyches of millions of merchants, employers, customers and laborers. Each indiviual who loses confidence in the value of money -- or becomes aware just how far it has already been debased -- starts the race to get rid of as much as possible before its worth drops any further.

As a result, says Gelb, every increment of inflation brings with it an increase in uncertainty. Prices cannot rise continuously (imagine thousands of store clerks constantly changing tags, or ringing up purchases with one eye on the clock), and so they leap upward in fits. Some merchants may readjust in the morning, others at night, and others at noon; prices thus depend unpredictably on where an item is bought and when, rendering the notion of a unified market meaningless. And if there is no market, Gelb says, inflation indexes cease to represent anything real: "Prices might be rising at 50 percent a month, but when you go shopping, the increase could be half that or twice that."

Faced with such massive uncertainty, he says, people avoid risk by abandoning the local currency for more stable alternatives such as dollars or deutschmarks. This capital flight adds more fuel to the inflationary firestorm and further reduces economic activity.

The spiral cannot last forever. At some point, usually within a year or so, a new government steps in and brings fiscal order, Sachs says. Once the money-printing stops, so does the inflation, and another nation emerges much poor but perhaps wiser from temptations of paper money. Hyperinflations stop even more abruptly than they start, according to Sachs; by the time stabilization comes, almost everyone is doing business in dollars or other "hard" currencies, and so fixing the value of the peso, real, mark or ruble is mostly a matter of convincing people to start using it again. Some nations (including Brazil for the fourth time this summer) change currencies as part of a stabilization program, the effect is mostly psychological, he asserts.

Ironically, inflation that stops short of complete monetary collapse may be more difficult to bring under control, he says -- when wages and savings are indexed, cost-of-living adjustments institutionalize rising prices. Finance ministries must carry off the most delicate footwork to give everyone the "last" increase, or else face a renewal of their woes.