One of the most striking aspects of Latin America over the last two decades is the reduction of inflation. In a region known for hyperinflation in the mid to late 1980s, inflation came down not only to single digit rates but to less than 5 percent –on average– in 2006, its lower rate in half a century. Only two countries in the region have double digit rates: Venezuela´s hovers around 20 percent while Argentina´s is closer to 10 percent (though price controls exist over some key goods and public utilities). Price controls, increased domestic liquidity and populist policies are elements tied to severe bursts of inflation in the region´s recent past, and have led some pundits to wonder whether high inflation –and even hyperinflation—may be on its way back in Latin America.
Hyperinflations and dinosaurs
Hyperinflation is defined as an inflation rate of more than 50 percent per month, after the seminal contributions of Philip Cagan in the mid 1950s. If this rate does not seem spectacular, note that 50 percent per month leads to an annual inflation rate of almost 13,000 percent. This is, indeed, so high an inflation rate that it may be considered as a dinosaur –a rare animal which existed but is now extinct. You may be in for a surprise because there is currently one country suffering from this precise malaise –though not in Latin America; that country is Zimbabwe, where inflation is reaching the 5,000% level.. Thus, hyperinflation is not dead. It helps, then to understand the conditions under which it happens.
Historically, hyperinflation is a relatively recent phenomenon that only saw the light in the 20th century. So high an inflation rate can only happen under very special monetary circumstances that allow for spectacular increases in the money supply tied to the financing of large fiscal deficits. The spread of fiat money (that is, unbacked paper money) in the twentieth century set the ground for the emergence of hyperinflations, and the more common occurrence of high inflations.
The hyperinflations that took place during the past century did not occur as isolated events, but rather came in bursts linked to global economic and political events. There are three distinct time periods when groups of countries succumbed to hyperinflation: the aftermaths of World War I and World War II, and the debt crisis of the 1980s. The first two periods affected European and Asian nations such as Austria, Germany, Hungary, Russia, Greece and China. The crisis of the 1980s affected principally Latin American countries: Argentina, Bolivia, Brazil, Nicaragua and Peru all succumbed to hyperinflation in the mid to late 1980s. Poland and Yugoslavia also fell in this trap at the time.
Each high inflation and hyperinflation has some unique characteristics that depend on the country in which it occurred, the time period, and the external circumstances. But all share significant common elements. One traditional view links hyperinflation with war, civil war or revolution, which seems plausible since two of the three time periods where it happened are related to war episodes. According to this view, the strain on the public budget brought about by the financing of a war effort leads to a major deficit that eventually becomes monetized.
A second view stresses weak governments which lack the ability to enforce tax collections ant to implement necessary budgetary reforms. These governments are easily temped to placate different groups of the population with transfers and subsidies in order to build up a political base. Under these situations they are likely to turn to inflationary financing. A third argument relates to external shocks (like the debt crisis) with budgetary implications. Under a fiat money regime, the value of the currency ultimately rests on the ability of the government to keep its current and future budgets under control. If economic agents feel that public finances may collapse they may provoke a speculative attack on the currency.
Latin America´s path
Since the early 1990s Latin America experienced a notorious decline in inflation (see figure 1). A transitory exception was Ecuador, which dollarized in 2000 at a wrong (over depreciated) parity and had to endure corrective inflation. Increasingly, countries have appreciated the benefits of macroeconomic stability, have reined in fiscal deficits and have made progress toward more independent central banks. In this way, they have removed then fundamental underlying cause of high inflation. Thus, in 2006 the average inflation of the region was below 5% for the first time in several decades.
It is, indeed, exceptional that all major countries in the region have been able to bring inflation to the 1% to 5% range, which is significantly more demanding than single digits. That is, with two notable exceptions. In Venezuela inflation is definitely not a priority; prices have been climbing in the neighborhood of 20% annually, and no credible stabilization plan exists. Argentina´s inflation rate, on the other hand, is around 10%. Yet it is safe to assume that the real inflation is above the official figure. This results from the introduction of price controls and export restrictions on several goods and services whose scarcity value is not reflected in their prices. Therefore, in Argentina the effective rate of inflation is several points above the official rate.
Although the people of Argentina and Venezuela would certainly benefit from lower inflation, they are certainly very far from the extreme price changes that Latin America saw in the recent past. The risk that one country in the region could develop a hyperinflation is, indeed, very slim. If we go back to the historical causes of this malaise, none of the elements associated with it are present today in the region. There is no armed conflict, no distinctly weak governments, and no significant negative budgetary shocks.
The true risk of high inflation in Latin America lies in populism. It is no coincidence that Venezuela is the country with the highest rate of inflation in the region –though low by historical standards. Hugo Chavez is the face of Latin American populism, though of a different brand; a rare mix of socialism and populism for export which can be sustained without an explosion of inflation as long as oil-related fiscal revenues remain generous. If that situation changes –and it will when the international cycle turns—the risk of high inflation is at the door. Hyperinflation is not dead, it is merely sleeping. Leaders like Zimbabwe´s Robert Mugabe are capable of awakening the monster.
Originally published in The Banker.