Wednesday, June 12, 2024
CommentaryThe Perils of Printing Money

The Perils of Printing Money

Government treasuries are frequently depleted following a major conflict or a heavy debt burden. Reviving the economy by increasing national output appears to take an eternity, whereas post-conflict economic crises may require immediate action. Governments instinctively seek an easy way out of the economic slump caused by unfortunate civil conflicts. They often print money in order to meet their debt obligations and ease the growing pressures on the economy.

The idea of simply printing new money to solve economic problems appeals to policymakers. Printing new money to circulate in excess of available goods and services in an economy would result in hyperinflation, worsening rather than solving the crisis.

Recent data show that Ethiopia’s inflation rate is expected to reach 34.5 percent, which would make it the third highest in Africa after Sudan and Zimbabwe.

Printing more money while national output falls or remains unchanged does not solve economic problems. Any economy suffers as a result of bad policy.

It merely increases the amount of “fiat money” (currency that is not backed by any commodity) in circulation. If more Ethiopian Birr (ETB) is printed in the hope of alleviating Ethiopia’s economic woes, those who receive it will demand more goods and services. When consumer demand goes up, producers whose output stays the same will almost certainly raise prices, which start the process of inflation.

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A simple model will demonstrate this.

Assume Ethiopia’s economy generates 50 million birr worth of houses per month and that 10 housing units are built and sold each month for five million birr.

The economy’s money supply is currently 50 million birr. If the government prints more currency and doubles the money supply while the economy still has 10 housing units, newly printed money will be spent on housing by consumers.

The demand for these 10 housing units would increase.

The obvious reaction to increased consumer demand is to raise the price of these homes. Because the birr has been doubled, the economy is now worth 100 million birr rather than 50 million.

The number of dwellings created per month remains constant at 10. Now, there would be too much money (the newly generated ETB on top of the existing currency in circulation) chasing too few products (the same quantity of housing units). As a result, rather than selling for five million birr, these homes will be priced at 10 million birr.

Doubling the amount of birr (the money supply) while keeping the number of housing units (output) constant results in a doubling in price, resulting in 100 percent inflation.

The injection of newly printed money into the economy would result in a nominal increase in national income, as measured by GDP. However, this growth in national income is really a monetary illusion. People get more money, but because all goods and services become more expensive, they are not better off.

In this simplified scenario, printing more money has not impacted the quantity of output, in this case, the number of dwelling units.

In economics, the relationship between the money supply and aggregate demand is well established. When both the money supply and the quantity of output increase proportionately, aggregate demand for goods and services remains constant, the average price remains constant, and there is no inflation.

However, when the money supply grows faster than output, demand rises, prices rise, and the overall price level rises. Inflation is a concern for numerous reasons, including that, in an ideal economic system, inflation of roughly two percent per year is seen as a typical economic event.

Even under normal financial conditions, money saved in currency is worth less each year unless it earns an interest rate greater than or equal to the rate of inflation. Periodic cost of living adjustments are another technique to ensure that pay keeps up with inflation.

Hyperinflation occurs when inflation rates spiral out of control and exceed 100 percent. At this point, prices are rapidly rising, as is the rate of increase. Hyperinflation harms the economy in several ways.

First, the value of savings decreases. In most economies, interest rates are set higher than inflation. If inflation is three percent, for example, interest rates would be five percent. As a result, if citizens keep their money in the bank, they preserve the real value of their money.

When inflation becomes out of control, the rate of inflation usually exceeds the interest rate. People who have savings find that the true value of their savings has decreased.

Then there are the economic costs of dealing with rapidly rising inflation, known as “menu costs.” Most goods and services, like food and drinks in restaurants, must have their price lists updated regularly to reflect the fact that prices are going up.

Hyperinflation also erodes the government’s credibility and public trust. Inflation can leave an indelible imprint on the minds of citizens who become suspicious of financiers, bankers, and the overall economic system.

Finally, hyperinflation dampens entrepreneurial confidence, undermining investment and economic growth.

Policymakers should be aware of some of history’s worst cases of hyperinflation, which occurred in Zimbabwe (2007–2008), the former republic of Yugoslavia (1992–95), and Germany (1922–1923).

Zimbabwe experienced a high level of hyperinflation in 2008. It was largely caused by the government printing money in response to a series of economic shocks.

Price controls, a large national debt, stagnant production, and a sharp decline in export earnings all contributed to the country’s hyperinflation. Prices doubled every 24 hours, and the government was forced to stop reporting official inflation statistics due to the volatile nature of the currency and exchange rates.

Yugoslavia’s hyperinflation was caused by regional conflict, local economic crises, and governmental mismanagement. In addition to the government’s unrestrained printing of money, internal conflict and regional destabilization were major contributors to hyperinflation.

Price controls disincentivize farmers, who can no longer profit from selling their crops, and, as a result, stores close to save their inventory rather than selling at government-set prices. Also, instead of getting rid of price controls and fixing the country’s supply, distribution, and money problems, the government started buying things from outside the country.

As supply shrank dramatically, prices continued to rise as goods became increasingly scarce. Businesses went bankrupt, and thousands of employees were unpaid for months or laid off. Prices increased by five quadrillion percent between October 1, 1993, and January 24, 1995.

In 1923, Germany’s Weimar Republic abandoned the gold standard and printed money to pay workers and war reparations.

As a result, the country experienced hyperinflation, which caused the prices of goods and services to double every four days. The exchange rate of Germany’s currency to the US dollar fell from 4.2:1 to 1,000,000:1. The economy deteriorated, which resulted in the emergence of Adolf Hitler and the Nazi Party.

Ethiopia owes more than 55 percent of its GDP to foreign lenders and creditors. Lenders assume that price levels in the country will remain stable in all cases.

If the government prints more money to pay off its debt or to finance capital projects without also increasing the nation’s output, inflation is likely to rise and reduce the value of its assets.

Inflation drives investors away from the country and forces lenders to demand higher interest rates. If inflation is not controlled, the government’s credibility will suffer. Its foreign lenders and creditors may take action to prevent the Ethiopian government from borrowing money from anyone.

Such a move would aggravate Ethiopia’s precarious macroeconomic situation. As a result, printing money would cause more problems than it would solve, and policymakers should avoid it at all costs.

(Yonnas Kefle (PhD), GTDC CEO, has worked as an economist at the Bureau of Labor Statistics, as a labor attaché at the US Department of State, and as an adjunct professor of economics at Frederick Community College and Pennsylvania State University. The views expressed in this article do not necessarily reflect those of The Reporter. He can be reached at [email protected].)

Contributed by Yonnas Kefle (PhD)

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