[Rational expectationists] are optimistic that inflation can be wiped out with little pain if only the government makes credible its determination to do so.
Hyperinflation---inflation of at least 50 percent per month---tends to devastate monetary systems so that barter takes over. Most modern analyses of inflationary spirals suggest that halting inflation requires protracted high unemployment; presumably, the more rapid the inflation, the more severe the adjustment. Surprisingly, several hyperinflations have been stopped almost overnight with minimal increased unemployment.
Figure 11 traces major hyperinflations in Austria, Hungary, Poland, and Germany after World War I. In each country, the abrupt halt in inflation was as spectacular as the rise itself. How did policymakers gain control of their monetary systems to end hyperinflation? The answer lies in the events preceding the hyperinflation and the actions taken to end it. Paul Samuelson's observation (above) provides a clue to the solution, but first let's examine the causes.
Figure 11 The Ends of Four Major Hyperinflations
Source: Thomas J. Sargent, Rational Expectations and Inflation (NY: HarperCollins 1986).
After World War I, Austria, Germany, Hungary, and Poland all faced severe hardships and financed massive budget deficits by printing fiat money; all except Poland owed sizable war reparations. Their currencies depreciated at alarming rates, and inflation had a momentum that appeared unstoppable. But in Thomas Sargent's view,
. . . inflation only seems to have a momentum of its own; it is actually the long-term government policy of persistently running large deficits and creating money at high rates that imparts the momentum to the inflation rate.┼
One rational expectations perspective is that stopping inflation, especially hyperinflation, requires more than just temporary adjustments in monetary and fiscal policy; the entire policy regime must be altered. Government finance must change in a credible way so that the public believes that government is committed to eliminating the abuses that caused hyperinflation. Such measures ended hyperinflation in all four countries.
First, all four governments created independent central banks that were prohibited from issuing unsecured credit. Second, all four committed to relatively balanced budgets and agreed to cover government debt strictly through bond financing. Finally, the debtor countries renegotiated war reparations. Thus, by altering the "rules of the game," these governments literally stopped hyperinflation in its tracks.
Argentina recently went through a similar experience. Throughout the 1970s and early 1980s, inflation in Argentina rose until it exceeded 500 percent per year. In 1985, a new government instituted austerity measures, a new currency, and the will to stop hyperinflation. By early 1986, relative normalcy had returned to Argentina. It appears that policies that worked after World War I in Europe continue to work today. A similar "cold-turkey" approach to the problem of government finance offers the only sure cure for hyperinflations raging in countries ranging from Yugoslavia to Russia to Brazil during 1992-1994.
┼Thomas J. Sargent, Rational Expectations and Inflation (New York: HarperCollins, 1986). This book discusses how several major hyperinflations were ended.