Jacob: I'm Jacob Clifford.
Adriene: And I'm Adriene Hill.
Jacob: And today, finally, Crash Course is going to live up to its name. We’re going to talk about crashes—economic crashes.
Adriene: Crash Course—we've been waiting for this!
Adriene: In Germany in 1923, people were doing strange things, like using money to wallpaper their houses and burning money for heat. What was going on? Had they all gone crazy? Nope! In the early 1920s, Germany was in the grip of something called hyperinflation. To pay massive reparations to the Allies after World War I, Germany printed a lot of their currency—the Mark.
One result of this additional money was higher and higher prices. By November 1923, it took a trillion marks to buy one U.S. dollar. There were one thousand billion mark notes in circulation. The mark was effectively meaningless.
A similar situation developed in Zimbabwe a few years ago. Starting in 2007, inflation grew rapidly—like really, really rapidly. By September 2008, the International Monetary Fund estimated the annual inflation rate at 489 billion percent. In practical terms, the Zimbabwean dollar lost 99.9% of its value between 2007 and 2008. It's hard to even imagine what that looks like. Prices nearly doubled every 24 hours, and businesses revised prices several times a day.
In June 2008, The Economic Times reported, “A loaf of bread now costs what 12 new cars did a decade ago.” The government issued currency in huge denominations to keep up with rising prices: the million-dollar bill, the billion-dollar bill, and finally, in 2009, the hundred trillion dollar bill—the largest denomination of currency ever issued. The good news was that everyone was a billionaire, but the bad news was that those dollars were virtually worthless.
Jacob: One definition of hyperinflation is when a country experiences a monthly inflation rate of over 50%, or around 13,000% annual inflation. But believe it or not, Zimbabwe’s recent inflation isn't unique, and it's not the worst inflation in history. In fact, the worst was in Hungary in 1946. Between July 1945 and August 1946, the price level in Hungary rose by a factor of three times ten to the twenty-fifth. And yes, any time you have to express your inflation rate using scientific notation, that's a bad thing.
Besides the obvious confusion over what prices to charge for things, why is hyperinflation so bad? Well, inflation—especially hyperinflation—erodes wealth. In Zimbabwe, people who had worked their whole lives and saved for retirement saw their savings just wiped out. Extreme inflation also forces people to spend as quickly as possible rather than save or lend, so there’s no money available to fund new businesses. All that uncertainty limits foreign investment and trade.
So, hyperinflation is bad. But how does it happen? Let's go to the Thought Bubble.
Adriene: So, we're simplifying this stuff a lot. But the root of the problem in both Weimar Germany and Zimbabwe was that the government was paying their bills by printing new money. An increase in the money supply can have two effects: it can increase output or increase prices, or some combination of the two. Inflation starts when output is pushed to capacity and can't rise much further, but policymakers continue to increase the money supply.
In theory, once output is maximized, the more money you print, the more inflation you'll get. Simple, right? Well, that doesn't fully explain why Germany's or Zimbabwe's inflation rose exponentially. Was the government really printing that much money? Not exactly.
After a couple of years of doubling prices, people started to expect high inflation, and that changed their behavior. Say you're planning to buy a new refrigerator, and you expect prices to rise quickly. You buy it as soon as possible before the price has a chance to change. But with everyone following that logic, dollars start to circulate faster and faster. Economists call the number of times a dollar is spent per year the velocity of money. When people spend their money as quickly as they get it, that increases velocity, which pushes inflation up even faster.
You get a vicious cycle of higher prices, which lead to expectations of higher prices, which lead to higher prices. The hyperinflation in Germany ended when the government replaced the worthless mark with a new currency. Zimbabwe ended its hyperinflation by abandoning its currency altogether. Now, its citizens use U.S. dollars or currencies from neighboring countries. The good news is that prices have since stabilized and real GDP has begun to increase.
Jacob: Thanks, Thought Bubble.
So, if you ever control a national economy, try to avoid hyperinflation. You might also want to stay away from depressions. A depression is kind of a hard thing to define, but basically, it's when real GDP falls and keeps falling for a long period. This has all sorts of terrible effects, like high unemployment and falling prices.
Before the 1930s, economists used the term "depression" to describe sustained falls in GDP. But after the Great Depression, economists started using the word "recession" for downturns to avoid association with the 1930s. I guess calling it a depression was just too depressing.
When the stock market crashed in 1929, it didn't just cause problems for stockbrokers. Everyone freaked out and stopped spending, and the economy ground to a halt. Of course, that’s not the only reason for the Great Depression. Actually, there’s still a lot of debate about the causes.
Anyway, when economies fall into deep recessions, there are more workers than there are jobs and more output than consumers want to buy. So, both income and prices fall. Central banks can try to use expansionary monetary policy to speed up the economy. For example, in the U.S., the Federal Reserve can lower interest rates. This encourages consumers and businesses to take out loans and hopefully get the economy going again.
But if people start changing their expectations and anticipate further price declines, they'll change their behavior in ways that work against the central bank. If you're planning to buy a refrigerator and you expect prices to fall, you're going to wait to get a lower price. But if everyone follows that same logic, then spending declines and so does the velocity of money.
That leads to further price declines and a vicious cycle of falling prices, which leads to expectations of lower prices, which actually leads to lower prices. It also leads to layoffs at the refrigerator factory, and so on and so forth.
This is called a liquidity trap, and some economists believe it's a worsening factor in economic downturns, including the Great Depression.
Adriene: Speaking of the Great Depression, after the initial crash of 1929, the Federal Reserve dropped interest rates to zero, output and prices fell, and regular people started to expect further price declines. Unemployment rose to 25%, and the average family income dropped by around 40%. This is not great. Once interest rates hit zero and prices were still falling, the central bank was in a bind. Continuing deflation meant that borrowing money was a bad deal, even with no interest. The money you pay back in the future would have more buying power than the money you originally borrowed. This discouraged people from buying homes or cars and discouraged businesses from borrowing to expand capacity.
In fact, getting out of the Depression took nearly a decade. And it wasn't really monetary policy that put an end to it; it was the massive government spending of World War II.
Okay, you don’t want hyperinflation. You don’t want depressions. You also don’t want stagflation. That’s when output slows down or stops or stagnates at the same time that prices rise. So, stagnant economy plus inflation equals stagflation. Get it? It’s a portmanteau.
Jacob: The U.S. experienced stagflation starting in the 1970s after a series of supply shocks, including a rise in oil prices and, believe it or not, a die-off of Peruvian anchovies, which were important for animal feed and fertilizers. This combination of events meant the economy couldn't produce as much. The Fed tried to address this by boosting the money supply and cutting interest rates, but output couldn't rise much because of low productivity and the oil shortage. So, all that extra money just triggered inflation.
It got even worse when people began to adjust their inflation expectations. Businesses started to expect costs to rise even further, so they laid off workers, which put the economy back into a recession. When the Fed boosted the money supply again, that raised inflation expectations even more.
This ended in the early '80s when a new Federal Reserve Chairman took over. His name was Paul Volcker. He actually cut the money supply and raised interest rates dramatically. Output plummeted, and unemployment reached ten percent, but prices stopped rising and so did inflation expectations. The economy gradually recovered, and Paul Volcker got the credit for ending stagflation.
So, hyperinflation, deflation, depression, stagflation—they're all extreme economic circumstances, but these extremes show us why it's so important to measure and understand the overall economy. In some cases, government action or inaction made things worse. In other cases, the government helped the economy get back on its feet.
But it's important to keep in mind that the economy is made up of the collective decisions of individuals. It's people like us; our expectations matter. If enough people fear a recession, they're going to decrease their spending, and that’s going to cause a recession.
Adriene: Next week, we’re going to look at different economic schools of thought. But regardless of philosophy, policies designed to steer the economy need to address expectations and focus on creating confidence.
Jacob: Thanks for watching. We'll see you next week.