The Land of 1,929% Inflation

March 24, 1994|By STEVE H. HANKE

Hjalmar Schacht, who was president of Germany's state bank before and during the Hitler years, once said, ''States and governments perish for two reasons: war and bad finances.'' In 1939 he pressed his views in writing and was summarily dismissed by Hitler.

Another German, Karl Schiller, who was economics minister between 1966 and 1972, made the same point about the toll exacted by war and inflation: ''Stability is not everything, but without stability, everything is nothing.''

A moment's reflection on the observations of Schacht and Schiller will lead to the sobering realization that most of the former Soviet republics are either engaged in wars, or suffering from high inflation or both. Consequently, the new world order is bound to become more disorderly.

Averting wars is the domain of diplomats; economists must limit themselves to finances. As a point of departure, we use data presented by Michael Pakko in the February issue of the Federal Reserve Bank of St. Louis' International Economic Conditions. Cautioning that the quality of the data from the republics does not meet international standards, Mr. Pakko presents inflation figures measured by the growth in consumer prices over the last four reported quarters.

The data are truly shocking. Estonia, where inflation is falling rapidly, registered the lowest inflation, with a 137 percent increase. That means prices have more than doubled in a year. Armenia topped the inflation chart, with a 1,929 percent increase. Prices there are nearly 20 times higher than a year ago. Inflation in ten other republics for which inflation figures were available ranged from 363 percent to 1,593 percent.

To cure inflation, a proper diagnosis of the disease is required. Unfortunately, the diagnosis made in the republics is flawed. It argues that since important sectors of the economy are monopolized by enterprises and unions, prices can be checked by wage and price controls.

The data presented in International Economic Conditions show just how far off-base this non-monetary argument is. Inflation in the republics, as elsewhere in the world, is a monetary phenomenon. There is a tight linkage between changes in the money supply and inflation. To control inflation, therefore, the emission of money must be arrested. Wage-price controls will only introduce further distortions into the republics' nascent price systems.

The control of money is easier said than done. Except for Estonia, which has the best inflation record of any republic, all republics employ central banks. Alas, central banks in developing countries have a sad history of printing money to meet short-term problems, thereby worsening long-term inflation.

World Bank data show a dismal record in countries with economies similar to the newly independent former Soviet republics: average annual inflation was 31.7 percent from 1970 to 1980 and 95.4 percent from 1980 to 1991. It is not surprising that political instability and government collapse has been endemic in these countries. Central banks simply have not worked well in developing countries.

With such a deplorable record, it is remarkable that the International Monetary Fund and virtually all other multinational institutions and Western advisers continue to proselytize enthusiastically on behalf of central banks. A notable exception has been Paul Volcker -- ironically, a former central banker. Markets existed long before central banks, he said in 1990, and central banks are not necessary to build markets. Indeed, Mr. Volcker anticipated that central banks would become an inflation curse on the republics.

If not central banks, then what?

The answer is in Estonia. In June of 1992, that republic rejected central banking and installed a currency-board system under which the Estonian kroon is fully backed by foreign reserves, trades at a fixed rate to the German mark and is fully convertible. Estonia now has the best record on inflation and economic growth of any of the former Soviet republics. Economic stability is providing a solid foundation for Estonia's economic autonomy.

Estonia's example has not gone unnoticed. Last week by a vote of 62 to 37, the Lithuanian parliament passed the ''Law on the Stability of the Litas,'' and Tuesday the president signed it into law. Lithuania will install a currency board April 1. That will be a necessary, but not sufficient, condition to ensure an independent, stable, free-market economy.

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University and state counselor on monetary and financial issues for the Republic of Lithuania.

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