Definition of hyperinflation: The rapid depreciation of the value of a unit of currency, leading to a sustained rapid increase in prices.
What is hyperinflation?
Hyperinflation is a rare market phenomenon where an economy becomes trapped in a vicious cycle of ever-rising prices. The best economics books will walk you through several notable instances of hyperinflation. We’ll also cover these at a high level further below.
Here is an illustrative example of how hyperinflation can take hold:
- A cash-strapped government decides to print vast sums of money to allow it to make payments on government bonds and other foreign debts.
2. These transactions cause an oversupply of money in the economy. This has the temporary effect of stimulating the economy, but as the underlying capacity of the economy has not increased, this serves only to increase prices – as more money chases the same goods and services.
3. Consumers, taking note of this inflation begin to bring forward large purchases (for fear of prices rising further). This additional demand becomes a self fulfilling prophecy pushing prices even higher.
4. Due to inflation, the value of the currency depreciates against other currencies. This is a logical relationship. In a high inflation environment, you need more of the same currency to buy the same product as one year ago. The logical conclusion is that each unit of currency has less buying power, and therefore forex traders will be prepared to pay a smaller quantity of other currencies to trade for it.
5. The weakening of the currency places pressure on the government, particularly where it has liabilities denominated in a foreign currency. An example might be a Latin American country with debt denominated in USD. As the currency depreciates, the debt becomes more expensive to pay off.
The government may conclude it has no choice but to turn up the printing presses even further. This way, it can create enough domestic currency to convert into foreign currency to settle the foreign debt.
6. A long term expectation of inflation begins to creep into the mindset of businesses and consumers.
Workers, wishing to avoid seeing their pay shrink in real terms, begin to demand high inflationary pay rises in anticipation of prices.
In turn, businesses also begin to raise the prices of products, to cover their rising payroll cost and to meet similar demands from their suppliers.
7. The collective effect of everyone continues raising their prices in an attempt to ‘keep ahead’ of the expected rate, creates an unstoppable engine which drives inflation into the state of hyperinflation.
How bad can hyperinflation get?
Due to the powerful effect of compounding, it’s possible for hyperinflation to reach thousands or millions of % each year.
Take a look at how the prices of German goods shot up in the dark economic period between the two world wars:
|Goods||1913||Summer 1923||November 1923|
|1 kg of butter||2.70||26,000||6,000,000,000,000|
|1 kg of beef||1.75||18,800||5,600,000,000,000|
|A pair of shoes||12.00||1,000,000||32,000,000,000,000|
Another example can be found in the economy of Zimbabwe back in 2008. Annual inflation hit a peak of 89.7 sextillion per cent year-on-year in November 2008.
What is the impact of hyperinflation?
There are many adverse impacts of hyperinflation which act to starve an economy during periods of excessive price rises.
Bartering becomes king
In a hyperinflationary environment, the money in your pocket could lose some of its value in the time it takes to run from your office to the shops to buy some food.
This makes it a terrible item to hold, but without it, modern economies can’t function effectively.
The benefits of paper currencies over bartering are quite obvious.
Currencies allow people to conveniently store value, allowing them to supply specific goods and demand specific goods without having to find another party who wants to make that exact trade.
Citizens of hyperinflationary economies are forced back into bartering, which produces inefficient transactions which give people less of what they want.
The hoarding of real assets
This hoarding is damaging to an economy, because these resources become idle and may deteriorate, instead of being used to produce and provide services. Therefore the supply of key goods becomes strangled by the impact of speculators.
New investment dries up
The economy enters survival mode. Investors spend their time trying to preserve their existing wealth, not generating economic growth.
All investment opportunities become riskier because their financial outcome becomes far more uncertain.
How is the word hyperinflation used in a sentence?
“The spectre of hyperinflation will strongly discourage a central bank from pursuing policies which would raise inflation above 3%.”
How does the definition of hyperinflation relate to investing?
Hyperinflation and real assets
This is because they are real assets, with an intrinsic value. If a currency depreciates rapidly, then the price of the asset should increase proportionately.
For example, if a share was worth $10 on Monday, then by Friday the currency has lost half of its value due to hyperinflation. Shareholders would simply demand twice as much to trade that share on Friday, or $20.
Thus, owners of real assets aren’t heavily impacted by hyperinflation – their wealth should remain constant in real terms.
Hyperinflation and monetary assets
This is because their value is pegged to a financial sum, priced in a single currency. If that currency depreciates, then the value of that fixed financial payment will be eroded further and further.
Whether it’s a coupon payment, the value of a bond at maturity, or the cash value of a savings account, these are all fixed in monetary terms. Therefore if that currency tanks – the value of these assets will plunge in direct proportion to the currency dive.
Some monetary assets have characteristics which may protect investors. Examples include index-linked gilts. These are government bonds which pay a coupon rate which is uplifted by an official rate of inflation.
Therefore the coupon payments from index-linked bonds should keep pace with skyrocketing inflation, and therefore help to cushion the blow to an investor.