All signs suggest that Afghanistan is likely to be in for a rough ride under the Taliban. The most urgent worries include potential reprisals against Afghans who helped the United States, violations of women’s rights, and the possibility that the country will become a haven for international terrorist organizations. 

The state of the Afghan economy seems to be relegated to a second tier of concerns, at least for the moment. However, there are already dire warnings that the economy will collapse, with prices exploding into hyperinflation. How likely is that? We don’t know yet, but this commentary explains what to watch for.

What is hyperinflation and where does it come from?*

Hyperinflation, loosely understood, simply means very rapid inflation. Percentage rates of inflation in the millions or billions have been observed in extreme cases like Weimar Germany after World War I, Hungary after World War II, Zimbabwe earlier in this century, and most recently in Venezuela. Afghanistan might well be next.

The origins of hyperinflation can be analyzed in terms of a simple formula called the equation of exchange: MV=PQ. In this equation, M stands for the quantity of money, V for velocity, P for the price level, and Q for the level of real GDP. Velocity, the least familiar term, can be thought of as the rate at which the stock of money circulates through the economy. Formally, it is defined as nominal GDP (that is, P times Q) divided by the money stock, M – a definition that makes the equation of exchange a simple accounting identity. 

For present purposes, it is more useful to rewrite the equation as P=MV/Q, which I call the “inflation accounting equation.” That equation makes it clear that any increase in the price level can be attributed to an increase in the money stock; an increase in velocity; a decrease in real GDP; or some combination of those factors. 

Some accounts of hyperinflation describe it as a result of “too much money chasing too few goods” – a formulation that implies a combination of rising M and falling Q. However, that is an oversimplification. For one thing, it neglects the key role played by velocity. More importantly, it ignores some critical feedback links among the variables that account for the explosive quality of historically observed hyperinflations.

The first feedback pathway acts through velocity and arises from the function of money as a temporary store of value. Hyperinflation undermines the store of value function because it causes money held idly in cash or bank accounts to lose significant purchasing power over even a few days. Rather than holding money, then, hyperinflation creates an incentive to exchange any money one has for something of more certain value as soon as possible. Economists call that asset substitution

Basic consumer goods such as canned goods or bags of rice are one alternative asset. If we look at what really happens in countries undergoing hyperinflation, however, the most popular substitute asset is a more stable foreign currency. People exchange their marks, Zimbabwe dollars, bolivars, or whatever for dollars or euros as fast as they can. 

The second feedback pathway operates through the impact of hyperinflation on real output. In your Econ 101 course, you may have encountered a relationship called the Phillips curve, which posits that higher inflation is associated with lower unemployment and faster economic growth. However, it turns out that the Phillips curve applies only to relatively moderate rates of inflation. At faster rates, inflation is harmful, not helpful, to the real economy. Rapid inflation makes business planning difficult, disrupts financial markets, and undermines the smooth operation of payments systems. Indirectly, it leads to labor strife, social disruption, political instability, and capital flight.

The third feedback pathway operates through the effects of inflation on fiscal and monetary policy. This pathway is less direct than those for velocity or GDP growth, but under conditions of hyperinflation, it can be quite powerful. 

The feedback begins with the effect of inflation on real tax revenue. No government has yet figured out a way to collect taxes instantly. If there is no inflation, the delay in receiving tax revenue does not affect its real value. However, when there is inflation, the real purchasing power of the tax revenue falls between the time the taxed activity takes place and the time the government receives the tax payments. By the time the government spends the tax receipts, the goods or services it buys cost even more. The combination of tax receipts that are worth less than they would be with stable prices, and spending that costs more means that budget deficits tend to increase as inflation takes hold.

The lag in tax collections, in turn, leads to an increase in the rate of growth of the money stock. When governments spend money on current purchases or transfer payments, the money stock increases, but that increase is normally offset, at least in part, by reductions in the money stock that take place when the government collects taxes. Under conditions of hyperinflation, however, the government may barely be able to collect any taxes at all, so that the entire budget deficit is turned into an increase in the money stock.

When we put these feedback mechanisms together, then, we see how even a moderate rate of increase of prices, P, can trigger an increase in velocity, V, which pushes inflation higher. The still-faster inflation undermines the real economy, Q, causing P to rise even more. Finally, rising P disrupts the government budget in a way that causes the money stock, M to increase, and the inflationary process feeds on itself. All episodes of hyperinflation for which we have solid data, from Weimar Germany to Venezuela, show this pattern in which rising P is accompanied by rising V, rising M, and falling Q.

Is hyperinflation inevitable in Afghanistan under the Taliban?

There is little doubt that at least some of the feedback pathways are primed and ready to explode in Afghanistan under the Taliban. 

Certainly, the Taliban takeover is going to disrupt the real economy. The disruption will be even greater if there is armed resistance to the takeover; if widespread reprisals result in the death, imprisonment, or retreat into hiding of a substantial part of the population; or if there is a wholesale withdrawal of women from the labor force. Certainly, financial markets and payment mechanisms will be disrupted. Q is going to fall.

Very likely, V is going to rise. The flow of dollars into the country through foreign aid and private remittances appears largely to have ceased. People who hold savings in the form of the local currency, the afghani, will rush to exchange them for dollars. If they can’t find dollars, they will try to exchange their afghanis for goods. Prices will be pushed up further.

But there may be some brakes on hyperinflation, too. For one thing, it is not clear what is going to happen to the money stock. The Afghan economy is highly cash-based and will become even more so if its already-weak banking system breaks down, which appears to be the case. Meanwhile, Afghanistan does not, at present, print its own currency. Afghanis are instead printed in the UK, which is probably not going to supply the Taliban with new bills in larger and larger denominations. It is, of course, possible that the Taliban will start printing substitute afghanis of its own on local printing presses and will do so in great volumes. That would definitely help fuel hyperinflation. However, it is also possible that they will use force to confiscate the goods they need and will drive workers and civil servants to their jobs at the point of a gun without paying their salaries. That would short-circuit the fiscal and monetary feedback mechanisms that have fueled hyperinflation elsewhere.

In short, there is certainly a risk that Afghanistan will drift into hyperinflation, but there is no certainty it will do so. Watch this space.

* This section is an abbreviated version of a longer discussion of hyperinflation theory taken from an earlier commentary, “Venezuela Plunges Into Hyperinflation.”