Hyperinflation in Weimar Germany: New Perspective on the “German View” using a Post-Keynesian Flow of Funds Framework

By Joseph Laliberté

Some of this material will be used for a future publication. Comments most welcome.

The “quantity theory explanation” and the “German view” are two schools of thought found in the literature to explain hyperinflation in Weimar Germany.

The quantity theory explanation emphasizes the role of fiscal deficits as the root cause of hyperinflation episode (Câmara and Vernengo, p. 1):

According to the quantity theory of money the origins of any inflationary process are to be found in irresponsible fiscal policies of governments. Budget deficits lead to the rise of a supply in money, and consequently higher prices. The solution to an inflationary process is to restore the principles of sound money either by reducing expenditure or raising revenues.

Or in the words of Kiguel (1989):

Hyperinflation, understood in this paper as a process of accelerating inflation, in fact occurs because governments have unsustainably large budget deficits...A correction of the fiscal imbalance has been crucial for stopping hyperinflation. This factor is well documented in the works of Yeager (1981), Sargent (1982), and Webb (1986) on the hyperinflation episodes in the central European countries during the 1920s and by Sachs (1987) on the more recent Bolivian episode.

There are many variants within the school of thought known as the Quantity Theory of Money. One major irritant from a post Keynesian standpoint is the notion that the money supply is exogenous and determined by the central bank. In general, proponents of the quantity theory explanation contend that although the government deficit may be the starting point of hyperinflationary episode, the key triggering factor of elevated inflation is to be found in the monetisation of this deficit by monetary authority. We will leave this last point aside for the purpose of this analysis and simply note the quantity theory focus on very large fiscal deficit as a key factor in accelerating inflation.

In opposition to the quantity theory explanation, German economists in the Republic of Weimar long contended that the imbalance created by the Treaty of Versailles in Germany's current account was the chief cause of hyperinflation. The balance of payment explanation, also called the “German view” in the literature, was in fact so prevalent in Weimar Germany, particularly at the Reichbank itself, that it was considered an official position (Laidler and Stadler, 1998, footnote 4). The lead proponent of the balance of payment explanation was Karl Helfferich, a German politician and economist, who was successively Secretary for the Treasury and Secretary of the Interior of the German Empire during WWI, and who wrote a book on money in 1927 (taken from Laidler and Stadler, 1998, p. 820):

First came the depreciation of the German currency by the overburdening of Germany with international liabilities and by the French policy of violence. Thence followed a rise in prices of all imported commodities. This led to a general rise in prices and wages, which in turn lead to a greater demand for currency by the public and by the financial authorities of the Reich; and finally, the greater calls upon the Reichbank from the public and the financial administration of the Reich led to an increase in the note issue.

Economists from other western nations have perhaps always looked with high suspicion to the “German view” because of its perceived political motive. Indeed, it was highly convenient for the German political class to blame hyperinflation on the Treaty of Versailles. Further, it did not help that Karl Helfferich himself was a German hawk during WWI and was responsible for a financial policy that contends that the cost of the war should be financed by borrowing rather than by fresh taxation (in other words, he was an interested party). These factors may explain why the balance of payment explanation as the root cause of hyperinflation has never been particularly popular among academics outside of Germany.

The objective of this analysis is to demonstrate using a post-Keynesian flow of funds analytical framework that, in conformity with the “Germany view”, the terms of reparations included in the Treaty of Versailles set the conditions for hyperinflation in Weimar Germany. Also, it seeks to show that hyperinflation in Weimar Germany is fully consistent with the existence of significant and on-going imbalances in both the current account and the fiscal situation.

After WWI, Germany was off the gold standard and on a floating exchange rate vis-à-vis other currencies such as the gold-pegged U.S. dollar. The Treaty of Versaille imposed heavy penalty on Germany relative to the size of its economy; by some estimates, reparations represented 20 times the total average German coal yearly output before the War, or nearly four times the average value of U.S., English or German annual exports before the war.

The Treaty of Versailles imposed two types of reparations on Germany: reparations payable in gold and reparations payable in real goods. It should be noted that the two types of reparations amount to the same thing: Germany was out of gold-denominated securities at end of WWI (due chiefly to its chronic current account deficit during the war itself, see here, p. 698), therefore the only way for Germany to obtain gold-pegged foreign currencies was through the exports of goods via the current account (or sales of assets abroad via the capital account).  We will assume therefore for the purpose of this analysis that all reparation was payable in real goods ("in kind" reparations). We have for Weimar Germany, the following standard flow of funds equation before reparations in period 0: 

1)      (G₀ - T₀) - (S₀ - I₀) = (M₀ - X₀)

Assuming the economy is at full capacity at a given price level P, and that E₀ is the equilibrium exchange between the German mark and the US gold-pegged dollar at which X₀=M₀, we have in period 0 (assuming the exchange rate is at E₀): [i]

2)      (G₀ - T₀) - (S₀ - I₀) = 0

The State was responsible for reparations, and paid for it using German marks. Therefore, reparations without a corresponding amount of new taxes directly increase Weimar Germany’s fiscal deficit. It should be noted that the price the German governments had to pay to entice German exporters to sell to the German government for German marks rather than export to foreign countries for U.S. gold-pegged dollars is a direct function of the prevailing exchange rate.  Denoting by Q the quantity of reparations in kind, we can define V₀ as the nominal value of reparations under Versailles denominated in German mark in year 0:

3)      V₀ = E₀*P*Q

The increase in budget deficit in year 0 therefore corresponds to V₀.  Substituting in the flow of funds of equation, we have:

4)      ((G₀ + V₀) - T₀) - (S₀ - I₀) = (M₀ - (X₀ - V₀))

Since M₀ = X₀, we now have the current account in a deficit by the amount of nominal reparations V₀.  So equation 4 could be simplified to:

5)      ((G₀ + V₀) - T₀) - (S₀ - I₀) = V₀

The current account, now in deficit, causes a reduction in the exchange.  Note: ΔE₁ is the change in the exchange rate.  It is to be interpreted as "the increase in % in the number of German mark you obtain from 1 US gold-pegged dollar". 

Thus we have the change in the exchange rate in period 1 which is a function of the nominal value of reparations denominated in German mark in period 0:

6)      ΔE₁ = f (V₀)

We also have:

7)      E₁ = (1 + ΔE₁)*E₀

Using equation 7, we can derive the following equation: 

8)      V₁ = (1 + ΔE₁)*E₀*P*Q

Combining equations 8 and 3, we obtain:

9)      (V₁ / V₀) - 1 = ΔE₁

Equation 9 says that the increase in nominal reparations denominated in German mark in period 1 relative to period 0 corresponds exactly to the depreciation of the exchange rate, itself caused by the current account deficit resulting from reparations payments in period 0 as shown above.  Re-arranging equation 9:

10)      V₁ = V₀*(1 + ΔE₁)

Pursuing with the same logic, nominal reparations denominated in German Mark in period 2 will be:

11)       V₂ = V₀*(1 + ΔE₁)*(ΔE₂ + 1)  

In period n, we will have:

12)       V_n = V₀*(1 + ΔE₁)*(1 + ΔE₂)*(1 + ΔE₃)* ... *(1 + ΔE_n) 

And so on and so forth.  Assuming a constant impact in percentage on the exchange rate (constant elasticity), we can simplify the above equation to:

13)       V_n  = V₀ (1 + ΔE)ⁿ

Substituting this equation in period n flow of funds equation, we have

14)       ((G_n+ (V₀ (1 + ΔE)ⁿ)) - T_n) - (S_n - I_n) = (V₀ (1 + ΔE)ⁿ)

Assuming n tends toward infinity, we are left with (denominated in German mark) an infinite nominal amount of reparations, as well as an infinite budget deficit coupled with an infinite current account deficit. Moreover, the value of the German mark relative to other currencies will tend toward zero. Reparations therefore had the effects of triggering a vicious cycle of ever-increasing current account deficit and ever-increasing fiscal deficit in Weimar Germany.

The very tendency to approach equilibrium in the current account through a decrease in the exchange rate was undermined by the ever-increasing nominal value of reparations denominated in German marks, which was itself caused by the decrease in exchange rate. In all likelihood, a country caught in this kind of cycle will eventually face a vicious inflation spiral unless it can afford politically to impose new taxes on its population in order to “confiscate” domestic consumption to pay for reparations. [ii]

Therefore, based on this analysis, the root cause of hyperinflation in Weimar Germany are to be found in the conditions as set out in the Treaty of Versailles regarding reparations.  Seen from a flow of funds perspective, the “German View” is therefore fully consistent with the existence of significant imbalance in both the current account and the fiscal situation.  

[i] These assumptions are made for simplification purpose. Altering them would not ultimately change the result of the analysis.

[ii] Clearly, the Weimar government could not afford politically to impose new taxes on its population. For example, Ladislaus Bortkiewicz, an economist in Weimar Germany, contended that the extreme fragility of Germany’s socio-political situation after WWI may have made inflation the most appropriate policy response (Laidler and Stadler, 1998, p.828).

References

Alcino Câmara and Matias Vernengo, The German Balance of Payment School and the Latin American Neostructuralists,  http://acd.ufrj.br/~coopegrid/pdfs/german%20balance%20of%20payment%20school.pdf

David E. Laidler and George W. Stadler, "Explanations of the the Weimar Republic’s Hyperinflation: Some Neglected Contributions in Contemporary German Literature", Journal of Money, Credit and Banking (Nov. 1998), pp. 816-831. http://www.jstor.org/stable/2601130

Miguel A. Kiguel, "Budget Deficits, Stability, and the Monetary Dynamics of Hyperinflation", Journal of Money, Credit and Banking, Vol. 21, No. 2 (May, 1989), pp. 148-157
http://www.jstor.org/stable/1992365

Federal Reserve Bulletin, ISSUED BY THE FEDERAL RESERVE BOARD AT WASHINGTON, various years, see for example: http://fraser.stlouisfed.org/docs/publications/FRB/1920s/frb_061923.pdf

Mythologies: Money and hyperinflation, http://rabble.ca/blogs/bloggers/progressive-economics-forum/2011/08/mythologies-money-and-hyperinflation

Thomas J. Sargent, "The Ends of Four Big Inflations", in: Inflation: Causes and Effects, University of Chicago Press (1982) http://www.nber.org/chapters/c11452.pdf