Fiat Hyperinflations in the Age of Crypto

In the age of crypto, fiat hyperinflations may be shorter, more intense, or might be avoided altogether if governments fear rapid (crypto-)dollarization

Feb 02, 2022

To people on Wall Street, crypto’s “decentralized finance” industry (DeFi) is very odd. DeFi doesn’t fund car loans or mortgages. It doesn’t issue credit cards. It doesn’t fund leveraged buyouts or underwrite IPOs or bonds. Instead, DeFi mostly provides leverage to risk-loving crypto traders that want to increase the volatility of their already volatile returns.

Unsurprisingly, there’s a popular narrative that DeFi is completely inward-looking and doesn’t matter to the outside world. That’s mostly true, but there’s more to the story. DeFi gave the world stablecoins, crypto currencies like Tether (USDT) and USD coin (USDC) that are pegged 1:1 to the U.S. dollar that have ballooned to a market cap of $150 billion.

Assuming they aren’t stamped out by regulators, stablecoins may change future fiat hyperinflations in developing countries, making them shorter but more extreme.

What is Hyperinflation?

There have been 57 hyperinflations in the world. That’s 57 cases where consumer prices have risen 50% or more in a month. Over half of all these episodes occurred in the 1990s in places like Azerbaijan, Georgia, and Estonia, due to the collapse of the Soviet Union and the transition to market-based economic models. In the 1970s and 80s, there were eight other hyperinflations, mostly in Latin America (Argentina, Brazil, Nicaragua, etc).

Obviously, hyperinflations are incredibly destructive. For one, they evaporate all savings in the banking system and crush real (inflation-adjusted) wages. Since everything denominated in local currency is rising all the time, hyperinflations dilute or destroy the information contained in prices, which is terrible for economic efficiency and productivity. Of all the kinds of economic crises, hyperinflation is among the worst.

The proximate cause of explosive consumer price growth is central bank money printing, but the root cause is almost always fiscal. Hyperinflations generally stem from unsustainable government spending, whether it is bloated payrolls, large debt repayments or whatever else. They can also stem from sudden collapses in tax revenue due to war or falling export prices.

When the budget deficit is too big for too long, capital markets can spook and start charging exorbitant interest rates for loans or stop lending to the government altogether, which forces policymakers into a dangerous corner.

Governments without access to finance can cut spending dramatically and restructure the economy, which is almost always painful, or they can keep spending with new money created by the central bank, which leads to even more pain, but sometime in the future. If governments opt for the second choice, the results are almost always the same. Like in Zimbabwe in 2007 or Venezuela in 2017, explosive inflation and currency depreciation follow.

Central bank money printing is often called the “inflation tax” because it is a way for the public sector to appropriate economic resources from ordinary citizens, especially people (and firms) that have large deposits in the banking system and anyone that earns wages in local currency. It is effectively a tax on bank deposits and wages, except it is much more distortionary and pro-rich than conventional taxes.

To summarize: hyperinflations are terrible, but they are relatively rare, and can only occur under a narrow set of circumstances. These are large and persistent government deficits, the depletion of voluntary financing for that deficit, and the unrestrained use of central bank money printing to plug the hole in the budget.

How do Hyperinflations end?

Hyperinflations end in at least two ways. First, with “orthodox stabilization,” when governments slash the budget deficit, implement structural reforms and get their act together, often with IMF support. If the government is serious about reducing money printing and getting its finances in order, this can cut inflation expectations and lead to a virtuous cycle of declining inflation. Orthodox stabilization is how the hyperinflation in Bolivia, Poland and lots of other places ended.

Second, hyperinflations can end as the economy slowly sheds the local currency in favor of a stronger currency that the government can’t print, forcing the public sector to make fiscal adjustments and live within its means. This is how both Venezuela and Zimbabwe’s hyperinflation ended.

It’s this second case that’s relevant to us.

If the government refuses to tighten its belt and keeps printing local money in spite of sky-high inflation, societies protect themselves by changing their asset holdings, swapping out local currency savings for durable goods, foreign currency and other assets like gold, stocks, and real estate which preserve value over time. This process turns local money into a “hot potato” that nobody wants to hold, which increases the circulation velocity of money and accelerates inflation in a vicious cycle.

As fewer and fewer people hold bank deposits and earn wages in local currency, society limits the resources that the government can siphon off through currency dilution. By slowly abandoning local money, countries become increasingly immune to the inflationary tax.

Over time, the process of demonetization and currency substitution can extinguish hyperinflationary episodes. As more and more people abandon local money in favor of the dollar or some stores of value, the local currency becomes increasingly irrelevant, sometimes to the point that the government is forced to recognize foreign money as legal tender. As the stronger currency takes root, the government’s incentives to continue printing money tend to zero. Eventually, the government is forced to live within its means and hyperinflation ends.

How might crypto change all this?

Before crypto, buying foreign currency in a collapsing economy that’s trying to limit capital outflows was relatively difficult, risky, or both. It required opening or having a foreign bank account, which is mostly only an option for bilingual, internationalized people. It required you to risk depositing foreign currency in a domestic bank, knowing it can be frozen or seized. Or it required you to hold foreign cash under the mattress, which is also risky. The options were limited, and the good options were mostly available only to a subset of educated, high-income individuals.

With crypto, more people can engage in currency substitution at an earlier stage in any economic crisis. Crypto wallets are free, and anyone with a smartphone or computer with internet can buy stablecoins (or BTC or ETH) with local money.

Even if governments implement currency controls, prohibit the purchase of foreign currency, ban centralized exchanges (like Coinbase or Binance), and impose limits to capital outflows, it doesn’t make much difference. Peer to peer (P2P) crypto exchanges have proven to be extremely resilient to regulatory crackdowns, as we have seen in Turkey and Nigeria.

As more user-friendly crypto products are developed and adoption increases, it will be easier for increasingly large segments of the population to participate in currency substitution when domestic policy turns self-destructive.

This will have two main macroeconomic effects. On one hand, the loss of value of the local currency against the USD (aka FX depreciation) will be more acute and extreme with all the additional demand for foreign currency from crypto adopters. This will obviously pass-through into consumer prices, raising inflation, inflation expectations, and accelerating the collapse of the local currency. Thus, crypto will make hyperinflations more intense.

On the other hand, crypto will also make hyperinflations shorter. Easier access to stores of value (stablecoins or cryptocurrencies) will accelerate the process of dollarization (or crypto-dollarization) that can otherwise take years. As a result, the economy will shed the local currency earlier, so the real value of printing local money for the government will fall sooner. This will precipitate inevitable fiscal adjustments and reduce the life of a typical hyperinflation.

Are there winners and losers? Does it matter?

Unfortunately, this is not good news for everyone. Even if it is rational for every individual to switch out of the local currency during a hyperinflationary episode, it pushes the burden of the inflationary tax onto other people that don’t or can’t do the same.

Rapid, uneven currency substitution will result in new “winners” (crypto adopters that join high-income/educated people in protecting themselves from inflation) but also in worse-off losers (other people that continue to pay inflation tax on their wages and savings).

From a welfare perspective, the shortened duration of acute inflationary episodes may outweigh the added intensity of the inflation and the pro-rich, pro-tech-savvy distributional effects. But this isn’t obvious, at least to me.

More interestingly, from a political economy perspective, shorter, more intense hyperinflations that end in dollarization sooner could also reduce the attractiveness of unsustainable fiscal policy and money printing, reducing the likelihood of bad policies in the first place. This is unclear, though, because governments that get anywhere near hyperinflation might not be the ones that care about these sort of nuanced arguments in the first place.

As Bloomberg columnist Matt Levine writes, stablecoins exploded in popularity as digital poker chips to park value on-chain in the DeFi casino. But these tokens may soon outgrow the analogy and find new life in turbulent developing economies rocked by the pandemic, potentially altering the course of a monetary history for countries with dangerously high inflation.

In the age of crypto, fiat hyperinflations may be shorter, more intense, or might be avoided altogether if governments are induced to fear rapid dollarization and adjust unsustainable policies to avoid it.

(If you want me to cover a particular topic in future or have questions or comments, say so in the comments section below. For an excellent academic overview of hyperinflation, see “Advanced Macroeconomics” by David Romer, Chapter 11.9 )