Hyperinflation: How can it be Reduced?

Published on 15th November 2005

One of the political comments that have emerged recently is the one comparing the Banbangida-Abacha years to the present regime in the economic management of Nigeria. It is common to hear related comments that unemployment has been increasing and living standards among Nigerians have been falling since the present regime came to power. While such comments are largely political, they also present an issue of understanding how a future regime tends to bear the costs of macroeconomic policies undertaken by past regimes, particularly when attempt is made to remedy those costs.

On the surface, it would appear that the present administration has managed the Nigerian economy relatively poorly. On the contrary, classical macroeconomics reasoning presented in this contribution suggest that the observed high unemployment rate, relatively lower rates of growth in Gross Domestic Product (GDP), hence declining living standards, are the \'price\' that Nigeria is paying for the unbridled inflationary policies of the past regimes, which the Abacha-Abubarkar regime attempted to salvage.

In 1995, inflation in Nigeria reached an unprecedented rate at 72.8%. This was caused mainly by rising prices associated with higher wages and excessive monetary injection into the economy through various channels, including huge expenditure on political transition of the immediate preceding years. Reducing this hyperinflation was at the centre of contractionary policies embarked upon by the Abacha-Abubarkar regimes. By
mid-1999 when Abubakar handed over power, inflation rate had declined to about 10%. As at the end of 2003, inflation rate was about 11.3%. These rates can be considered as moderate by developing countries standard.

Attempt to reduce hyperinflation is understandable. Costs of inflation include increased variability of relative prices, liquidity preference rather than investment, unintended tax liabilities, changing unit of account, and arbitrary redistribution of wealth between debtors and creditors. However, classical macroeconomics shows the trade-off between high inflation and unemployment, especially in the short run. A period of high inflation is accompanied by a period of low unemployment, and vice versa. Thus, any observed variations in the unemployment rate can be traced to attempts at reducing inflation.

Reducing inflation generally involves slowing the economy down through contractionary policies; monetary and/or fiscal. The government can reduce monetary growth, streamline government expenditure, and execute low budgets. The effect of these policies would be to reduce aggregate demand by firm sand households. This in turn reduces the quantity of goods and services that firms produce. The fall in production will lead to higher unemployment (fall in employment).

If a government is to reduce hyperinflation, it must endure a period of high unemployment, low output, hence lower standards of living. In the short-run, say in 3-5 years, inflation will reduce, but at a cost of higher unemployment associated with lower GDP. How long it takes the economy recover (this is back at its natural level of unemployment/output) depends on the magnitude of the hyperinflation rate when it first occurred.

The cost of reducing inflation is commonly summarized in a statistic called the sacrifice ratio. The sacrifice ratio is the proportion of annual GDP (measured in percentage points) that must be sacrificed with attendant higher unemployment during the transition from the period of high inflation to low/moderate inflation.

The above reasoning can be tested using macroeconomic data published by the Central Bank of Nigeria (CBN) covering the period (1995-2003). These data are available in the CBN\'s website. Growth rates are calculated on inflation rate, GDP (at 1984 constant factor cost), and unemployment rate (the sum of low grade workers, professionals, and executives who registered as unemployed with the Federal Ministry of Employment, Labour and Productivity).

In about five years preceding the Obasanjo regime, (1995 - mid-1999), inflation rate decreased by about 36.8% on average per year. GDP declined by about 10% and unemployment increased by about 9% rates, on average per year, respectively. During Obasanjo\'s first term in office (mid-1999 - 2003), inflation was actually increasing by about 33.4% rate on average per year. GDP increased by about 4.6% rate per year, while unemployment declined by only 0.26% points on average, suggesting that the economy is gradually picking up.

Combining both regimes (1995-2003), so that the present administration is allowed to inherit the effects of previous regimes\' attempt at reducing inflation, inflation rate decreased by about 1.7% rate on average per year, causing a decline of about 2.7% rate in GDP per year, and associated unemployment rate declined by about 9% rate per year.

Dividing the GDP effect by the inflation rate (in absolute terms) (2.7% / 1.7%) gives an estimate of the sacrifice ratio at about 2% per year. This suggests that every 1% reduction in inflation rate since 1995 led to about 2% decrease in the GDP per year. Thus, for Nigeria to reach a moderate inflation rate, say 10% per year would mean reducing the 1995 hyperinflation (72.8%) by about 63% points. But this would require sacrificing about twice as much (126%) of annual GDP. If this 126% is spread over a 10 year period (say to 2004), then the decline in GDP would have to be about 12.6% on average per year, other things being equal.

Other interesting results also emerge from the simple analysis. Firstly, the analysis confirms the inflation-unemployment trade-off. Secondly, the implications contrast between the periods of ambitious disinflation drive under Abacha-Abubarkar regimes and the period of gradual inflation under the present regime. The rates at which inflation was declining in the immediate years preceding the present government\'s first term in office and the rate it was increasing thereafter are comparable (compare 36.8% and 33.4%).
However, the implications for GDP and unemployment contrast sharply between the two regimes. The GDP decreasing effect under Abacha-Abubarkar regimes was about twice (compare 10% to 4.6%) as great as the GDP increasing effect under Obasanjo\'s regime, and the associated unemployment effect.

Thus, the benefits of moderate inflation are small the present administration relative to when Abacha-Abubakar ambitiously seek zero inflation. The message is clearly one of making a choice between small benefits associated with moderate inflation (higher income and declining growth in unemployment) and high costs (lower income and increasing unemployment) associated with disinflation. Obviously, the small benefits are better than the high costs.

Moreover, the real effect can be seen by looking at what the 2% sacrifice ratio means for the living standard of the average Nigerian. In 2003 non-oil GDP, this sacrifice ratio corresponds to about N248 billion in national output. Based on population estimate of 120m, this figure represents about N21million per person. We might dislike inflation, but it is debatable whether we should be willing to sacrifice this much in order to get rid of
it.

The welfare cost of reducing inflation tends to be larger than this N21million, especially if one considers how the lost income will be distributed among Nigerians. This lost income is not spread equitably across the population. Rather than for all incomes to fall proportionately, the fall in national income will be concentrated on those workers (for example) who lose their jobs with attendant effect on their families. The most vulnerable Nigerians are the low skilled, inexperienced, and new job seekers. Thus, much of the cost of reducing inflation is borne by those who can least afford to \'pay\' it.

The simple lesson is that once a hyperinflationary economy is created, (eg. by a regime before it leaves office), reducing it (by subsequent regimes) would not always be easy. Attempt at reducing hyperinflation tends to impose long term costs on the economy. Unfortunately, political commentators tend to attribute such costs to poor economic management by subsequent regimes that assume power. Whereas the economy is simply \'paying\' the price of the hyperinflation created in the past.

In conclusion, many people are quick at making comparison between Abacha and Obasanjo regimes in macroeconomic management of Nigeria. However, they ignore the reasoning that economic policies undertaken today can have greater and long term unintended consequences for the economy in the future. The perceived declining living standards among Nigerians today are a result of the unbridled expansionary policies under Babangida regime, which Abacha-Abubakar attempted to remedy.

Living standards depend on productivity, not on expansionary/inflationary policies. Because inflation in nominal incomes goes hand in hand with inflation in prices, reducing inflation would not suddenly cause real incomes, hence living standards, to rise rapidly. What Nigeria is experiencing today has been experienced in Europe as recent as late 1990s. Economists have traced the high unemployment in many European countries
since the mid-1990s to the disinflationary policies embarked upon during
1980s.

Published by the Institute of Public Policy Analysis http://www.ippanigeria.org/
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