Hanke and Kwok have written a paper in the Cato Journal estimating the hyperinflation in Zimbabwe in November last year. They conclude that the monthly (not annualized) inflation rate of 80 billion percent was the second highest in world history (next only to Hungary in July 1946).
I was at first skeptical about the methodology that they use. Since Zimbabwe stopped publishing inflation data during the period, Hanke and Kwok rely on the share prices of the South African insurance and investment company, Old Mutual, in the stock markets in Harare and London. This involves making two assumptions:
- that the relative price of the Old Mutual share in the two countries provides a reliable estimate of the exchange rate of the Zimbabwe dollar; and
- the depreciation of the exchange rate is a good estimate of the inflation rate in Zimbabwe via purchasing power parity (PPP).
I thought that both assumptions are highly suspect for reasons that I explain below.
We do know that, absent capital controls, the relative share price of the same company in different countries tracks the exchange rate very closely. This was true as early as the eighteenth century (Larry Neal, “Integration of International Capital Markets: Quantitative Evidence from the Eighteenth to Twentieth Centuries”, Journal of Economic History, 1985) and it is even more so today. Even the well known paper of Froot and Dabora (“How are stock prices affected by the location of trade,” Journal of Financial Economics, 1999) found problems with the pricing of twin stocks but not the prices of the same twin in multiple markets.
At the same time, exchange controls can play havoc with this assumption. For example, Indian ADR prices trade at large premia to the underlying Indian shares. The difference between Shanghai and Hong Kong share prices of mainland China companies reflects the same phenomenon. These examples suggest that relative prices could be off by nearly a factor of two in the presence of stringent capital controls.
In the kind of lawlessness that prevailed in Zimbabwe, the margin of error is I think higher. I would not be too surprised to find a deviation of prices by as much as a factor of ten.
The second assumption about PPP is even more suspect. Under normal conditions, PPP does not hold up too well except over the very long run. Lothian and Taylor needed 200 years of data to demonstrate that PPP does hold at all (“Exchange rate behavior: The recent float from the experience of the last two centuries,” Journal of Political Economy, 1996).
One would hope that to the extent that PPP is held back by sticky prices, the extreme flexibility of prices during hyperinflation would make PPP hold better. I think there is merit in this argument.
However, in situations like Zimbabwe, the US dollar would probably be valued more as a store of value than as a medium of exchange. The exchange rate is then driven by asset market considerations rather than goods market considerations. Extreme financial repression in which the real rate of interest on Zimbabwe dollar could be hugely negative (approaching -100%) would make the US dollar extremely attractive. People would then buy the US dollar not on the basis of what it is worth now, but on the basis of what it will be worth in future. At the same time, it is impossible for a foreigner to go long on the Zimbabwe dollar without assuming Zimbabwe sovereign credit risk and legal risk.
Under these conditions, I would not be surprised if the exchange rate undervalued the local currency by a factor of ten or more. Taken together with the earlier factor of ten for the stock price, this implies that Hanke and Kwok could be off by a factor of 100.
Surprisingly, this would make very little qualitative difference to the results of Hanke and Kwok. The monthly percentage rate of inflation in Zimbabwe that they estimate is roughly 80 billion. Revising it down by a factor of hundred would bring it down to 800 million. That is still higher than the third highest rate on record (Yugoslavia, January 1994) of 300 million. No plausible margin of error in the opposite direction will bring Zimbabwe within even shouting distance of the highest recorded hyperinflation (Hungary, July 1946) which was 4 followed by 16 zeroes.
Put differently, to push Zimbabwe down to third place, the Hanke and Kwok estimate would have to be off by a factor of 250. Much as I dislike the smug confidence that Hanke and Kwok seem to have in arbitrage relationships in a society where there is security of neither life nor property, I find it difficult to argue that the arbitrage relationships may be off by a factor of 250.