Within the scope of this in-depth research, we will elaborate on hyperinflation and its effects on society. The Serbo-Montenegrian hyperinflation of 1992-1994 is the second fastest in history. In January 1994, the culminating month of the hyperinflation, consumer prices increased 310 million % per month, compared with a maximum monthly rate of 30 thousand % per month in the great German hyperinflation of 1923. The average monthly inflation rate was 1,660% exceeding Greece, 1943-1944 (1,070%) and Germany, 1922-1923 (320%), and second only to Hungary II, 1946 (360,000% per month).
The first thing to note is that the Serbo-Montenegrian hyperinflation was remarkably long, lasting 22 months as conventionally measured (inflation of over 50 per cent per month). Only Nicaragua (1987-91, 48 months) and China ( 1947-9, 26 months) were longer (3). It thus lasted significantly longer than its closest competitors in terms of speed (Hungary II 12 months; Greece 13 months; Germany 16 months).
A number of ‘step increases’ in the rate of inflation seem to have occurred: beginning 1992, second quarter 1992, January 1993 and August 1993. In November 1993 the exponential inflationary explosion began. The remarkable thing, in a way, is how late this happened (sixteen months after conventionally measured hyperinflation began).
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Two forces drove the Serbo-Montenegrian hyperinflation: sharply declining real balances, which meant that the inflation tax base was declining, so that ever higher inflation rates were required to obtain the same inflation tax revenue (Table 2); and, a powerful Tanzi-Olivera effect, which sharply reduced the real value of conventional taxes (although not all the data sets available point to this latter effect).
Thus at the end of the hyperinflation the total real domestic money supply amounted to less than $4 per capita in Serbia Montenegro. This means that on average the total domestic money supply may have been changing hands as often as twice a day at this time. (1) As the cost of holding money–the expected inflation rate for cash and the expected inflation rate minus the expected nominal interest rate for deposits increases, real money balances decline and the velocity of circulation increases.
The surprising thing is that, in spite of this collapse in real money balances, seigniorage revenue has been estimated as having remained remarkably stable, oscillating around $140 million per month, close to the level achieved in 1992 when the rate of inflation was far lower (7).
In other words, even at the extraordinary inflation rates registered in Serbia-Montenegro in 1993-4, the inflation-tax Laffer curve does not seem to have bent backwards. Moreover, seigniorage remained stable at inflation rates far above the 500 per cent per annum, which, it has been claimed, has been the seigniorage maximizing inflation rate in modern Latin American episodes.
The second engine of the hyperinflationary process in SerbiaMontenegro has been the Tanzi-Olivera effect. Hyperinflation severely reduced the real value of conventional tax revenues, so that even with a given level of seigniorage, government expenditure has declined sharply as a share of GDP (and has declined even more sharply in real terms, as GDP itself has fallen). (5)
The process of erosion of real tax revenues seems to have accelerated during 1993: conventional tax revenues in the last quarter of the year were running at an annualized rate of $700 million (Table 3). The authorities attempted to offset the Tanzi-Olivera effect by shortening the period of tax collection. Thus the weighted average of the delays in cashing fiscal revenues was 20 days in the first quarter of 1993, 15 days in the second quarter, 10 days in the third quarter, and 5-10 days in the fourth quarter.
In the first three quarters of the year the shortening of the tax collection period just offset the acceleration of inflation, and about 50 per cent of the real value of tax revenue was lost in each of these quarters. In November the loss was between 59 per cent (five day delay) and 83 per cent (ten day delay), and in December the loss was between 71 per cent and 95 per cent. The monthly estimates of real conventional tax revenue given in Table 3 seem to confirm this.
One can distinguish a number of different sectors of the Serbo-Montenegrian society as regards means of payment and price setting behavior. The first was the so-called ‘green market’ where farmers sell food and alcohol. Here prices were set in Deutsche Marks throughout 1992 and 1993. (5) Those wishing to pay in Dinars had to pay at the current street market rate of exchange, possibly with a mark-up.
At the other extreme there was the ‘official economy’, consisting of all large shops, whether state, socially owned or private, all large businesses (non-financial and financial, also state, socially owned and private), and transactions between the state and the rest of the economy.
In this sector all official transactions were effected by the use of cheques. (4) In between was the host of small private businesses (e.g. shops, taxis), which theoretically had the obligation to accept payment in Dinars and by cheque, but where compliance might be difficult to enforce.
A number of phenomena occurred, especially during the second half of 1993, which show that at these kinds of inflation rates the price mechanism can break down, with important and costly real effects. The most important was the appearance of widespread shortages. These were initially due to the misguided price freeze, which the authorities introduced in late August 1993. (8)
However, shortages were not eliminated in ‘official sector’ shops after prices were freed in October. This was because prices were rising so rapidly that it was often impossible for retailers to buy the same real volume of goods with the proceeds of a given day’s sale as had been sold (i.e., the inflation rate over the turnover period exceeded the sales margin). (2)
As one would expect, in response to accelerating inflation, prices were set for shorter and shorter intervals: until October this was usually once a week, then it increased to twice weekly, ending with twice daily price changes in small shops in January 1994.
However, large shops and supermarket chains felt unable to change their prices more than once daily because they did not have bar code systems. As a result, changing prices in the middle of the day could have led to a severe risk of till fraud, as employees could have registered sales at the lower morning prices and put the difference in their own pockets. (6)
These shops responded in a number of ways. The first was to reduce the number of goods, which they sold. One large supermarket chain reported that in October-November 1993 it was actually selling only cheese, eggs, pasta, bread, and milk, and that from about 10 December 1993 it sold only bread and milk. (3) The reason for this reduction in variety was stated to be that it made it easier to avoid loss in real terms.
Perishable foods were discontinued, while non-perishables either had their prices set at intentionally prohibitive levels or were withdrawn from sale and kept in warehouses. The same supermarket chain increased the frequency of its purchasing strategy meetings from daily to twice daily at the end of November 1993, showing that even when prices are completely free, hyperinflation causes many of the symptoms of a shortage economy to appear.
The second tactic was to reduce the length of opening hours. The supermarket chain already quoted reduced its opening hours from twelve to seven per day. There were two reasons given for this: first, there was less time for the fixed prices the shop had set to fall far below the highest prices which consumers were prepared to pay; second, the repricing of goods every day required a significant amount of time. Although the prices of most goods were intentionally set at prohibitive levels at this time, nevertheless, with inflation so rapid many of these prices had to be updated daily to remain prohibitive.
In Serbia-Montenegro the situation was made worse for official sector retailers by the obligation they had to accept cheques, since these took a number of days to clear. (7) They responded by setting prices, which were a considerable margin above those in the small shops (which had different prices for cheque and cash transactions). The result was that the large shops were only used by those paying by cheque.
Taken on a daily basis the acceleration of inflation appears far smaller, and allows us to understand how it was that any kind of money based economic activity remained possible. One important question to which it was unfortunately impossible to obtain a clear answer was the extent to which inflation during the day was a continuous phenomenon, and to what extent it was discrete.
Much of the folklore of hyperinflation assumes a continuous process, for example the famous anecdote that in Germany in 1923 it made sense to buy two beers at once when in a bar, as the second beer became warm more slowly than its price increased. (5) However, such anecdotal evidence as was obtained tended to indicate that even at the dizzying rates of January 1994, in Serbia-Montenegro most prices were set for an appreciable period of time (e.g. one working day, or half a working day). Beyond a certain point, the acceleration of inflation led merely to larger discrete price increases, with a significant reduction in working hours to make inter-temporal arbitrage to the disadvantage of the seller more difficult.
In the small business sector prices were generally set twice a day, on the basis of the black market exchange rate. (6) Even this allowed arbitrage, as holders of hard currency waited until the exchange rate moved (apparently this was usually around midday), bought dinars, and then rushed to buy goods as quickly as possible, before their prices rose in response to the new exchange rate.
One example of continuous pricing which proves the rule of its absence, is the case of taxis. These set their meters in notional units and were then informed by their dispatchers what price to charge on the basis of the current exchange rate. Obviously, this was impossible for most businesses, which did not have access to up to the minute information on the exchange rate.
The practical difficulties of continuous price adjustment for most businesses explains both prohibitive pricing and the physical withdrawal of goods, and the use of actual foreign currency (rather than merely pricing in foreign currency which was also formally illegal). The first point is of considerable theoretical and policy importance. It explains why a sufficiently rapid hyperinflation can lead not only to the misallocation of resources, but to the breakdown of the market mechanism, just as price control does.
As regards policy, it is important to note that the pervasive shortages of the second half of 1993 in SerbiaMontenegro only began to disappear with the introduction of the stabilization programme at the end of January 1994. Second, if stabilization is impossible, then the preservation of the market mechanism in extreme hyperinflations of the Serbo-Montenegrian kind requires the legalization of the use of foreign currencies, which are stable.
A phenomenon, which has been noticed in a number of the faster hyperinflations, is the fall in output, which accompanies these episodes (1). Serbia-Montenegro follows the same pattern, with industrial production falling at an accelerating rate as inflation itself has accelerated.
The falls in industrial production were: 17.6 per cent in 1991, 22.9 per cent in 1992 and 37 per cent in 1993 (3). It can be argued that the primary cause of the fall in output in Serbia-Montenegro are the UN sanctions to which the country is subject. However, the fact that industrial output stabilized after the ending of the hyperinflation–with February being the first month in which it did not fall when seasonally adjusted–suggests that we may be dealing with something of wider significance.
A number of mechanisms have been proposed to explain how hyperinflation could cause output to fall. The first is that the inflation causes ‘noise’ which makes it harder to interpret price changes as being relative or not. As a result the allocation of resources is less efficient, and the true value of output falls (5). However, it is unclear why such a fall, while truly costly, should show up in the industrial output statistics.
A second suggestion is that the dramatic fall in the value of real balances inevitably means a roughly equivalent fall in real credit. (8) The problem is that often a large part of seigniorage is actually transferred to nonfinancial businesses in the form of cheap central bank credits, so that on a flow basis industry is actually obtaining additional liquidity at the expense of households (4).
Observation of the Serbo-Montenegrian hyperinflation suggests two additional possible mechanisms. The first is an extension to the non-retail sector. The greater the range of products one produces, the greater the risk that one will fail to reprice them all adequately, and that one will sell some at below replacement cost.
One way of dealing with this problem is to reduce the range of one’s products. If goods are not perfect substitutes in production, this will lead to a fall in output. The second point is that once hyperinflation reaches Serbo-Montenegrian levels, domestic money is held exclusively for transaction purposes. Production requires undertaking transactions, which requires the holding of domestic money. Engaging in production thus means exposing oneself to the inflation tax, which thus becomes a tax on production.
That inflation itself was reducing output is indicated by the fact that industrial production recovered quite sharply after stabilization. It is worth noting that neither of the last two mechanisms, which may have acted to depress output during the hyperinflation, would have operated if the use of foreign currency, so-called currency substitution, had been legal (7).
An interesting phenomenon is the way the state tried to offset the Tanzi-Olivera effect not only by reducing tax payment periods, but also by increasing tax rates. Payroll taxes were increased to 222 per cent. There was a 3 per cent tax on the value of all payments made by cheque.
The result was that by the end of the hyperinflation tax rates were totally unsuited to a non-inflationary environment, and needed to be very sharply reduced if the economy was not to find itself on the wrong part of the conventional tax Laffer curve. This added a further dimension of uncertainty to any attempts at estimating budget revenues for 1994.
The history of the Serbo-Montenegrian stabilization is the story of the successive abandonment of the unconventional elements in the Avramovic programme. By early February the ND to OD exchange rate was effectively fixed, so that there never really was a bi-paper standard in the country.
In March and April 1994 the stabilization programme was further changed in ways which brought it closer to conventional programmes: fiscal policy was made more restrictive and monetary policy was made looser with the re-introduction of fractional reserve banking (with quite low reserve ratios).
The reason for the tightening of the fiscal stance seems to lie mainly in Serbia’s international position. The initial programme was built on the assumption that there would be peace in Bosnia by the summer of 1994, that sanctions would be lifted, and indeed that an IMF stand-by facility could be negotiated shortly thereafter. (3)
The main purpose of the programme was therefore to enable the Milosevic group to survive politically until the summer of 1994. This was to be done by allowing the government to recover its ability to command resources, which had been ravaged during the hyperinflation by the destruction of the real value of conventional tax revenue through the Tanzi-Olivera effect. However, the NATO ultimate of February and April 1994 seem to have brought about a more realistic view in Belgrade.
It was no longer sufficient to be able to maintain the machinery of government functioning through to the summer. A recurrence of hyperinflation before the end of the war had to be avoided at all costs. And since the war might not end in the foreseeable future, policy had to aim at permanent–rather than at temporary–stability.
As regards the longer-term success of the stabilization, one can only say that the welcome fiscal tightening seems to have been more than compensated by excessive monetary loosening. Nevertheless, whether the Avramovic plan is successful or not in the medium term, the fact that it worked initially is of both theoretical and policy importance. It is apparent from the above analysis that hyperinflation has tremendous effects on all sectors of society and all aspects of social life in any given country.
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