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Understanding Money

Inflation and Hyperinflation

To appreciate how the Internet is important to the world economy of the 21st century, it is necessary to understand the major economic forces of the 20th century. One of the most significant forces was the threat of inflation.

Throughout this essay, I have discussed examples of inflation, a condition in which the prices of goods and services increase significantly for an extended period of time. In the 20th century, there were a number of occurrences of extreme inflation, called HYPERINFLATION, in which prices skyrocketed beyond all reason. Before I can explain how this can happen, I need to spend a moment discussing the advantages — and disadvantages — of paper money.

The original purpose of paper money was to provide a convenient way to represent more tangible forms of money. For example, a paper note could be printed to represent a specific amount of gold or silver. Merchants would accept the note because they knew that, whenever they wished, they could present the note to the issuing agency — a bank or a government — and exchange it for the actual gold or silver.

Since paper money was a lot more convenient than coins, few people actually traded paper for gold. However, because people believed they could make the trade, they had faith in paper money, and it was this faith that made the whole system work.

From time to time, governments or banks would print more money than they had real gold. This, as we discussed earlier in the essay, would cause inflation, which would create economic instability. However, inflation alone is not enough to make an economic system fail. An economic system does not fail until the people lose faith in the currency. In the 20th century, this happened many times, always with disastrous results. The most interesting example occurred after the Russian Revolution when the new government deliberately sabotaged their own currency.

In February of 1917, the regime of Tsar Nicholas II was overthrown and, nine months later, in November 1917, the Bolsheviks, led by Vladimir Lenin, seized power. The Bolsheviks (who, in 1918, changed their name to the Communist Party) promoted an idealistic philosophy in which all property, including the means of production, should be owned and administered by the state for the good of the people.

Some of the newly powerful Communists dreamed of building a society without money. The plan called for money to be replaced by a rationing system based on coupons that would be allotted by the state. To destroy the current monetary system, the Communists printed as much money (rubles) as everyone wanted. Within a short time, the monetary system was effectively destroyed by hyperinflation: paper money had lost so much value that it took 10,000 new rubles to buy something that, before the revolution, cost only one Tsarist ruble. Within a few years, however, it became obvious, even to the Communists, that the country could not function without money and, in 1921, the government was forced to introduce a new currency.

The most extreme case of the collapse of a currency occurred in Germany after World War I. The war had lasted from 1914 to 1918. Germany and her allies had lost the war, and the other European countries, particularly Great Britain and France, pressed for extreme retribution. The details were specified by the Treaty of Versailles, which was negotiated in 1919 by the United States, Great Britain, France and Italy. The treaty sharply reduced Germany's power and gave some of her land to other countries. It also established the League of Nations, the forerunner of the United Nations.

Most important, the treaty placed the blame for World War I on the Germans, and ordered them to pay the cost of the war. Although the U.S. objected, the other countries, in April 1921, presented Germany with a huge bill of 132 billion German marks. This was equal to about $33 billion U.S. dollars (about $329 billion in today's dollars). Although most of the blame for World War I did lie with Germany, their economy had been devastated by the war, and the terms of the treaty made it difficult for them to sell goods for a fair price on the open market.

The German government did begin to make payments to other countries. However, the Germans were not able to meet even their own domestic obligations, so in order to come up with the money, the government began to print large amounts of paper money without any tangible backing. The result was a severe debasing of the German currency. Within several months, prices in Germany started to rise. As the government printed more and more money, prices rose without bound, and the government found itself needing to issue paper money faster than it could print it.

How bad was the situation? In November 1919, just after the war, one U.S. dollar cost about 4 German marks. By July 1922, a dollar cost 500 marks. By January 1923, the cost had risen to 18,000 marks. At the height of the German inflation, in November 1923 — four years after the war — a German mark was worth so little that it cost 4,200,000,000,000 (4.2 trillion) marks to buy a single U.S. dollar. In other words, in November 1923, one U.S. penny was worth 42 billion German marks.

The hyperinflation finally ended on November 29, 1923, when the German government created a new currency in which each new mark was worth a trillion old marks. One U.S. dollar was now worth 4.2 new marks. To keep the currency stable, the government based the new money on land values. In 1924, the U.S. loaned Germany $200 million so it could return to the gold standard, which further stabilized the new German money.

However, by 1924, the damage had been done. Extreme inflation had placed a great financial burden on the Germans, especially on the working class and the middle class. This burden, combined with a general resentment over the harshness of the Treaty of Versailles, created great suffering within Germany. This suffering, in turn, fostered long-standing discontent and an atmosphere of political extremism, leading to the conditions that allowed Adolf Hitler to come to power in the early 1930s. In 1935, Hitler unilaterally nullified virtually all of the Treaty of Versailles.

The German experience with hyperinflation was extreme, but it was by no means unique. The 20th and 21st centuries saw a number of countries succumb to this deadly economic malady, among them Bolivia in 1985, Argentina in 1989, Peru in 1990, Brazil in 1993, Ukraine in 1993, Kosovo in 1994, and Zimbabwe in 2007.

Such occurrences are serious because they affect more than one particular country. Not only is an entire region destabilized, but the economy of the world as a whole can be affected. For example, at the height of the hyperinflation in Bolivia, Bolivian merchants and consumers were able to achieve a certain amount of stability by establishing a large black market economy using U.S. paper money. In order to make the system work, however, the Bolivians required an ever-expanding supply of American cash. The principal way in which they accumulated this cash was to export coca paste, which was used to make cocaine for the U.S. market. Once the drugs were sold on the streets of America, the cash was shipped back to Bolivia where it was used to support the underground economy.

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