Budget Deficits, Hyperinflation,
and Stabilization in Ukraine: 1991-96


[1] In 1995-96, Ukraine's inflation slowed, and its record high price increase of 10,558 percent in 1993 was surpassed in 1994 by Georgia and Armenia, among the central Asian republics of the former USSR.

[2] An eighth occurrence, technically, took place in January 1992; but the 435 percent leap in prices that month was largely due to the partial price liberalization that took place in Ukraine and Russia at that time.

[3] Growth rates are exponential growth rates, such that, for example, g = ln(CPIt/CPIt-1). The continuously compounded rate varies in proportion to the length of the period, so that the quarterly rate is three times the monthly rate. The advantages are that a quick "eyeball" comparison is straightforward, and econometric analysis is facilitated.

[4] An advisor to the National Bank of Ukraine, Georgés de Ménil (1996) examined two seeming "paradoxes" of Ukrainian money. First, if the peak year of monetary emissions was 1992, then why was 1993 the year of hyperinflation? The rate of monetary emission declined by about a third from 1992 to 1993. If so, then why did inflation accelerate so dramatically in 1993? Second, in 1992-96 actual inflation exceeded the calculated "equilibrium" rate of inflation (computed as the rate of inflation consistent with the observed average annual rates of seigniorage, velocity, and real GDP growth). Why did actual inflation seemingly exceed levels consistent with the simple logic of equilibrium inflation? Significant for present purposes, De Ménil resolves these paradoxes by relating inflation to money growth, with a lag of three months.

[5] Note: M3 = M2 + foreign currency deposits.

[6] "Base money" is defined as currency in circulation plus banks' reserves (including cash in vaults).

[7] That is, it depends upon the sensitivity of the demand for money to marginal changes in its purchasing power. At base, this is a matter of both the public's confidence in the currency, and the credibility of the government's commitment to defend it.

[8] Unpublished estimates referenced in de Mnil (1996).

[9] In 1993, for instance, Nova Ukrayina (New Ukraine) faction leader Volodymyr Scherban, People's Deputy from Donetsk, filed a suit against the government with the Procurator General's office to prevent such "asset stripping." Deputy Premier Pynzenyk has also been a staunch opponent of such confiscatory policies. See IntelNews, "Government Accused of Confiscating Property," December 1, 1993, p. 3.

[10] Indeed, the IMF (1996, table 12, p. 40) attributes to households nearly 100% of the average annual increase in currency in circulation.

[11] If anything, these percentages are overstated just a bit, since enterprise cash holdings have not been excluded from the household money series. In any case, along with the IMF, the author believes that enterprise cash holdings were minimal.

[12] This observation is based on the author's meetings and interviews with, among others, former Minister of Finance Hryhoriy Piatachenko, First Deputy Finance Minister Mykola Syvulskiy, and Deputy Minister of the Economy Volodymyr Naumenko. National Bank of Ukraine officials were not immune to the persistence of Soviet-era thinking about the role of money in the economy. For instance, the author attended a conference on "The Economy of Ukraine: Today and Tomorrow" hosted by Deputy Premier Victor Pynzenyk in August 1993, where Ms. Galina Kuznetsova, Head of the Department of Monetary Policy of the NBU, stated flatly that the Ukrainian inflation was not a monetary phenomenon, but the result of distortions in retail pricing brought about by monopoly enterprises.

[13] For instance, Former Finance Minister Hryhoriy Piatachenko persisted in arguing, as late as March 1994, that Ukraine's monetary problems were an instance of the "goods-money-goods" formula described in detail by Karl Marx in Das Kapital. Indeed, this "applies to [Ukraine] straight out of the book." A further indication of the government's attitudes at the time were provided by Piatachenko's rather telling assertion that "there is nothing bad about the fact that in 1993 the National Bank of Ukraine issued KBV 25 trillion in cash." See Serhiy Borysenko, "Piatachenko Defends 1994 Budget," IntelNews, March 2, 1994, p. 4.

[14 ] It is exceedingly difficult to measure the quantity of foreign currency held by households. Almost none of it is deposited in banks. According to officials at the NBU, foreign currency deposits "on the record," as it were, are almost entirely in enterprise accounts.

[15] Ben Slay, "Ukraine Finally Introduces the Hryvna," OMRI Analytical Brief, No. 303, 27 August 1996. (Internet, )

[16] Prompted by Yushchenko's repeated affirmations that the new currency would be introduced by the end of 1996, the Kyiv Universal Exchange reported trading futures contracts in the hryvnia. Trading began at a rate of 100,000 KBV to 1 HRV, rising marginally to 101,604, a remarkable forecast of the conversion ratio announced three days later. See: "Ukrainian Exchange Begins Futures Trading in the Hryvna," OMRI Daily Digest, No. 163, Part II, 22 August 1996. (Internet, )

[17] Obviously, it was important to maintain public confidence in order for the monetary reform to succeed. Previous attempts to introduce the hryvnia were defeated by a lack of public trust. For instance, in July 1995, President Kuchma announced that the government would introduce the hryvnia in October of that year, precipitating a run on U.S. dollars, which increased inflation sharply in August. In hindsight, it is clear that the Ukrainian public, still reeling from the material and psychological effects of inflation in 1992-94, possessed little confidence in the government's ability to carry out a non-confiscatory reform. Not until government credibility had been restored, in part, by returning to key positions such respected economic reformers as Deputy Premier Victor Pynzenyk, and controlling inflation for several months' time, was introduction of the new currency possible.

[18] Victor Yushchenko, "Monetary Reform in Ukraine," The Ukrainian Legal & Economic Bulletin, November 1996, pp. 11-13.

[19] "Ukraine Extends Currency Exchange Deadline," OMRI Daily Digest, No. 181, Part II, 18 September 1996. (Internet, )

[20] Victor Yushchenko, "Monetary Reform in Ukraine," The Ukrainian Legal & Economic Bulletin, November 1996, pp. 11-13.

[21] The argument of Sargent and Wallace (1981) is that monetary policy to check inflation fails in the long run because the real stock of bonds grows faster than the rate of growth of the economy as a whole. For some period, such supernormal growth is possible; however, a limit will be reached where the demand for bonds grows no further. Once that point is reached, debt service on bonds already issued would have to be financed through additional money creation. Knowing that they are to be repaid with cheaper currency, bond investors simply stop buying the government's paper. Thus, in the long run, Sargent and Wallace conclude that tight money must yield to additional inflation. The alternative, of course, is for the government to stabilize immediately.

[22] The institutional placement of the NBU has not changed under the Constitution of Ukraine ratified in July 1996. However, under the new appointments process, the NBU Governor is more difficult to remove, which provides a measure of increased central bank independence. Only time will tell if this arrangement proves sufficient for the NBU to steer an independent course in the monetary realm.

[23] Buiter (1987) essentially argues that, with rational expectations, "hyperinflation is impossible, but hyperdeflation may get under way" (p. 112). The reason is that people will be on their money demand function in a rational expectations equilibrium. If we assume that the demand for real balances is a function only of expected inflation, then seigniorage equals the sum of the inflation tax plus the change in real balances. Where lax fiscal policy is accomodated through money issuance, seigniorage will cover government deficits. However, in a steady-state equilibrium, with constant real balances, seigniorage equals the inflation tax, and the rate of inflation is constant (that is, inflation is stable from period to period). If the fiscal deficit grows to be too large to be financed by the revenue-maximizing steady-state equilibrium rate of inflation, then real balances must grow to provide additional seigniorage. That is, real money demand has to increase. And here's the rub: This would require that inflation actually falls. Hence, Buiter concludes that, under rational expectations, unsustainable government deficits will give rise, not to hyperinflation, but to declining inflation. A further inference Buiter draws is that the monetarist's recommendation that governments pursue currency stabilization through fiscal austerity is unwarranted.

[24] Von Hagen (1994) essentially argues that, even in a rational expectations regime, if expected inflation is below current inflation, a deficit larger than that which can be financed using the maximum steady-state seigniorage level can still be covered through an increase in real balances.

[25] Partial price liberalizations occurred in Ukraine in January 1992, coinciding with Gaidar's moves in Russia; January 1993, when oil prices were raised by several times their previous level; and November 1994, when the state drastically reduced consumer subsidies, and raised prices on many consumer items several times their previous level. According to de Mnil (1996), these repeated liberalizations had the effect of "disturbing whatever underlying equilibrium relationship between deficits and inflation may be at work" (p. 10).

[26] Even the otherwise economically-savvy former Economics Minister Roman Shpek was not immune from the impulse to blame external forces, indicated by his statements to the effect that Russian fuel price increases were to blame for Ukraine's 1993 hyperinflation. See Marta Kolomayets, "Government Announces Price Hikes for Food, Transportation, Electricity," The Ukrainian Weekly, December 12, 1993, p. 1.

[27] On the topic of adaptive expectations, see Sargent (1993).

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