Today's question, from Roslyn, is:

I read today that Zimbabwe's inflation rate has hit 231 million percent. What drives inflation so high in some countries? How can Zimbabwe return inflation to a reasonable level?

Roslyn,

I'm not sure inflation has ever been described more eloquently than by Ronald Reagan, who complained America's inflation problem was of "too many dollars chasing too few goods." That is, an increase in all prices will occur due to an increase in the number of dollars floating about. Zimbabwe has simply printed too many dollars.

We've all heard about those hyperinflations, like the Weimar inflation of 1923-24, when an old guy would cash out his retirement savings to buy a sodapop. But for what reason do countries allow them to happen in the first place?

The answer can be told by looking at a few historical hyperinflations. An early hyperinflation occurred in what we now call New England, during the seventeenth century. Lacking a superior monetary authority, the de facto currency of the region was tobacco, which was durable, divisible, and transportable--all good traits of money. As hoards of pilgrims landed in Boston harbour, one could wander down to the docks with just a few pounds of tobacco, and purchase a freshly imported wife. The savvy bachelors among Boston's small population saw a good deal here, and began to plant tobacco, wholesale. This increased the money supply, and so, like in Zimbabwe, began to increase the price of brides. Just a few years later, the cost of wiving had rocketed in terms of tobacco; one would have to horse down cartloads of dried leaf for the purchase of even an ugly girl. The lesson, however, was not learned.

A few centuries later, an uncharacteristically smart Irishman called David O'Keefe came across Yap, an island now in Micronesia (I'm not sure where it was before). The Yapese used small round stones specific to Palau, a boat-ride away, as their currency. As the fairly primitive Yapese had trouble transporting these rocks, they formed an acceptable currency. O'Keefe, with his large boat, smelled opportunity. With a taste for Melanesian ladies and sea cucumbers, he saw the small cost of sailing to Palau to collect rocks worthwhile, for what (or who) he could purchase. In increasing the Yapese money supply in this manner, the currency was debased, requiring larger and larger denominations--just like the Zimbabweans, who until August had denominations up to the trillion. The rocks became larger.

Today, Yapese villagers still use large stones for some transactions, though they use US dollars for small ones. The stones, in some cases up to three or four metres across, can be used to purchase livestock, houses, and (you guessed it) brides. Some stones--the especially large ones--are not even moved around, but merely transferred in ownership between one holder and another. I guess that saves a trip to the bank.

While these two examples are entertaining, they do not exactly describe why Zimbabwe has needed to expand the money supply so violently. The cause lies, unsurprisingly, in the madness of their dictator, Mugabe, and the international reaction to his rule. When a government needs to raise money, it can do so in two ways--either tax or borrow. When subjects aren't able to be taxed, the government will borrow. When the citizens are too poor to borrow from, the government must borrow from abroad.

As Mugabe destroyed Zimbabwe's export economy, by removing efficient white farmers of their land,
he also starved the country of access to foreign capital. This meant when the government went cap in hand to international financiers, the cap stayed empty.

The only option left to the government was then the worst--to monetize the deficit. This involves the government selling bonds (which they repay only by selling more bonds) to the central bank, who pays them in currency. This is when the money supply begins to accelerate. The inflation accelerates because, at any given level of inflation, more money supply growth must occur for the government to have any additional purchasing power.

The solution, without revolution, is simply to dollarise (or randise). This involves giving up on domestic currency (and the lack of credibility of the domestic monetary authority), and importing credibility of a foreign central bank. Whilst this has costs--relinquishing monetary policy, and the capacity to absorb exogenous shocks via exchange-rate depreciations--they would, in Zimbabwe's case, be less than the cost of inflation.

The other option is regime change, though this has not been shown to restore confidence in the monetary authority (Feige, 2003; Kraft, 2003; Velarde, 2002). My Zimbabwean friend Bethel tells me unofficial dollarisation is occuring, though access to foreign currency is very limited.

Poor bloody country...