The Little Book of Economics: How the Economy Works in the Real World, Revised and Updated

Chapter Five

Fire and Ice

Warning: Inflation and Deflation Are Toxic to Your Economic Health

When Yugoslavia dissolved into a bloody civil war in the 1990s, there were more than just ethnic and religious rivalries at work. Inflation, the continuous rise in the prices of almost everything, was also a factor. Thanks to an economic crisis in the early 1980s, prices in Yugoslavia were rising at annual rates of more than 1,200 percent by the late 1980s. Inflation helped dissolve the cohesion of Yugoslavia’s multiethnic middle class. Some people protected themselves by growing their own food or hoarding foreign currency. Others watched their incomes and savings get wiped out.

Throughout history, high inflation has often led to social upheaval. Hyperinflation, when prices rise by 50 percent or more per month, helped bring the Nazis to power in Germany and the communists in Russia and China, and topple both civilian and military governments in Argentina. These, of course, are extreme forms of the disease. But far more modest rates of inflation in the 1970s helped bring Margaret Thatcher to power in Britain in 1979 and drive Jimmy Carter from the White House.

Why is inflation so destabilizing?

Prices are the market’s air supply; they signal surpluses and shortages and tell businesses and consumers when to produce more or consume less. Inflation contaminates this air supply. Suppose you are thinking of opening a new hotel in a city where room rates are rising 10 percent, thinking that must ...