William Easterly
The Elusive Quest for Growth
High inflation crazily inverted the lecture your grandfather gave you on how compound interest could multiply savings. In your grandfather's lecture, saving your pennies makes you rich if you wait long enough. In the inverse version, high inflation reduces riches to pennies if you wait too long.
Argentina sets the record for highest and longest inflation, with an annual average inflation of 127 percent per year from 1960 to 1994. Thus, Argentines had the most potential in the world for money meltdown. If an Argentine with the equivalent of $1 billion in savings had kept all of his money in Argentine currency since 1960, the real value of his financial holdings in 1994 would amount to a thirteenth of a penny. A candy bar that cost 1 Argentine peso in 1960 cost 1.3 trillion pesos in 1994. To avoid having to use trillions in prices for candy bars, Argentina had done numerous monetary reforms where it asked the public to exchange 1 zillion 'old pesos' for 1 'new peso.' Then prices were thereafter quoted in 'new pesos.'
It's not a big mystery why inflation creates bad incentives for growth. Because of the money meltdown, people try to avoid holding money during high inflation. Inflation is effectively a tax on holding money. But this avoidance of money comes at a price, because money is a very efficient mechanism for economic transactions. We can think of money as being one of the inputs into efficient production. Inflation is then like a tax on production.
Moreover, inflation diverts resources away from producing things to producing financial services. A study has found that financial systems, measured by the share of financial services in GDP, get bloated during high inflation, and so productive sectors get short shrift. This makes sense: individuals devote a lot of resources to protecting their wealth during high inflation, resources that get taken away from productive uses. People respond to the incentives to divert resources toward protecting their wealth and away from creating new wealth. Trying to have normal growth during high inflation is like trying to win an Olympic sprint hopping on one leg.
