...against fictions and other tall tales

Thursday, 18 October 2012

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 V0So 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)       Vn = V0*(1 + ΔE1)*(1 + ΔE2)*(1 + ΔE3)* ... *(1 + ΔEn

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)       Vn  = V0 (1 + ΔE)n

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

14)       ((Gn+ (V0 (1 + ΔE)n)) - Tn) - (Sn - In) = (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).


Alcino Câmara and Matias Vernengo, The German Balance of Payment School and the Latin American Neostructuralistshttp://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

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


  1. Joseph,

    A bit unsure as to what you are trying to do here. One could carry out your kind of analysis for any debtor nation but that doesn't prove that these nations see runaway inflation.

    While war reparations is definitely a part of the story - you need another one - a wage-price spiral.

    1. Joseph Laliberté19 October 2012 at 08:55

      You are correct, this constitutes only the first part of the story. The second part must necessarily include wage-price spiral (any publication on the subject would obviously have to include that second part). I thought it was important initially to focus on the current account, the fiscal situation and the exchange rate mostly for two reasons:
      1) in order to find a common thread between the quantity theory focus on the fiscal imbalance and the "german view" focus on the current account/exchange rate.
      2) in term of chronology of events for Weimar hyperinflation, there is somewhat a consensus among historians/economists to say that the collapse in exchange came first. So I thought it was important to focus first on the current account aspect.

      With regards to your comment: "One could carry out your kind of analysis for any debtor nation but that doesn't prove that these nations see runaway inflation." Perhaps I do not read it correctly, but are you suggesting that it is quite common for a debtor nation to be imposed a foreign-denominated liability almost overnight, and be further told to pay back X% of it by the end of next year, or else face military action. This is what the Allied Powers in effect told Germany through the Treaty of Versailles. Unless mistaken, I think this is a rather unique set of circumstances.

    2. JL,


      Also, I am not suggesting that it is common.

      What I suggested was that your proof with sectoral balances doesn't highly depend on whether the conditions you highlight were met or not and/or the size of the reparation. Or at least doesn't seem to depend in the first look.

      How does it matter in your taking limits (and finding convergence or divergence) if it were $1 or $100bn?

      So the limit of the sequences you show to be divergent should ideally depend on the size of the reparation compared to other numbers such as GDP, net assets etc, right? (Such that for sufficiently low reparation it doesn't diverge and for a large one it indeed diverges).

    3. Joseph Laliberté22 October 2012 at 08:35

      I would say so. Size of reparations relative to GDP matters a great deal. I guess if you assume that Weimar Germany was managing its exchange rate at E* in order to generate a current account surplus (before reparations), and reparations would have just resulted in a decrease in the current account surplus (but still maintain a positve balance in the CA), then Weimar Germany could have continued to manage its exchange rate at E*. (I would note however that Germany's current account was in deficit throughout WWI and thereafter, so this scenario clearly would not apply)

      Moreover, assuming reparations result in a current account deficit, AND also assuming that foreigners have an infinite desire to accumulate German marks, then no collapse in exchange rate would have ensued. Weimar Germany could have *theoretically* generated infinite amount of fiscal/current account deficit.

      So ultimately conditions for divergence would need to take into account: (reparations/GDP) as well as the desire of foreigners to accumulate german mark.

  2. JL, you write:

    "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"

    Could you also include a situation where a nation is unable to impose additional taxation for technical or operational reasons (e.g, inability or weakness to enforce taxation)?

    1. Joseph Laliberté19 October 2012 at 09:21

      Yes, I would say so. I do not think this was the case in Weimar Germany though. Institutions were sufficiantly strong in Weimar (I think) to ensure proper tax collection. It was more the political cost of imposing new taxes that was the barrier. Perhaps this is one aspect where Weimar Germany differs so much from other hyperfinflation episodes (such as Zimbabwe for example).

      Regarding inflation as the only politically possible response, even the Austrian economist Ludwig von Mises expressed that the hyperinflation was the best response available to the Weimar government in the face of politically unsupportable demands for reparations. (source: Laidler&Stadler, p.829)

  3. This is very good work M. Laliberté. Although much has been done, most commentators and analysts have focused on specific causalities rather than trying to bridge correspondences and establish the possible convergence of diverse macroeconomic visions. One aspect you may wish to consult before going further is the macroprudential breakdown of the system. I recall you tapping that area in FRB a while back, and found the initiative insightfully promising. Much has been done with regards to the Great Depression but limited work has been properly done in respect to the Weimer Crisis. Your best Virgil is Eichengreen in the matter for two reasons: he addresses the problematic within the parameters of policy and internationalizes the scope of the issue. Failures are usually systemic failures; destabilization is usually a result of poor pragmatics and limited scope on credible policy. (You may also look at the classic canon: Blackburn and Christensen, and shelf Goodhart& Illing eds. as a complement what policy gems!!!).
    On Helfferich I would only emphasize that he was an ideologue of the worst kind and this skewed his work as a good politician. One blind spot as an apologia on taxation as a no-go is that the fiscal solution was never adequately addressed for a corporate clientele. The second issue is to raise the question of why corporate Germany was not permitted to engage in more aggressive commerce with the gold banner-bearers that were the UK, France and US. Manufacturing capacity was not the problem. Ironic is that contemporary Germany's emphasis on austerity is actually a tax metaphor for the targeted sovereigns. Consider the consequences.
    On the methodological side, have a peek at Graziani's insights- I am sure that Laidler would not disapprove- he may find pleasure in being in the company of that great counterpart. Let us recall that Messrs. Lavoie and Godley have honored the Italian on more than one occasion. As have Circuit and FRB readers !!
    I look forward to your next section on the wage/price maelstrom.

    Well done! Stay the course.

    1. Joseph Laliberté24 October 2012 at 12:04

      Thanks for your insightful comment,you clearly know a lot about Weimar. I will make sure to read the references you provided.

      I agree that manufacturing capacity was not the problem; even if it was, a one time shift in inflation would likely result, not a continuous acceleration of inflation.

      Good point on corporate Germany not being allowed to engage in more agressive commerce with gold banners-bearers. I know that the Weimar Government actively tried to control imports and exports (not with much success given the current account picture). Archives of the Federal Reserve Bulletin has good information on this.

      I am curious about what you mean by "...is that the fiscal solution was never adequately addressed for a corporate clientele". Could you please explain?

      many thanks,

  4. Joseph,

    Just to add to Swells's (nod!) comments and suggestions, you may also be interested in Tom Humphrey's (FRBR) views on German Inflation. I always found his work lays out the different theories in a clear and comprehensive fashion. Although he doesn't find the balance of payment theory of inflation very credible, his take can't be avoided. TM Humphrey is an excellent economic historian -- very few know more about the fundamental money-related historical debates like him.

  5. One of the deterrents of fiscal policy is the effort to address corporate resistance. Theoretically and to some limted extent pragmatically, stabilization programs are usually inserted within a countercycical paradigm. The latter are particularly effective when properly coordinated by credible authorities with strong international support. However one is disappointed by the results of such implementations on corporate sponsors. The US tried half century ago and disappointed.

    1. Joseph Laliberté26 October 2012 at 09:06

      thanks for your comment. Both you and B.Swells touched on the implications of fiscal policy on the corporate sector in your comment. Could you expand on this? (I asked the same question to B.Swells...I am really curious about this aspect)


    2. On CC and AS, not to be audacious but the recent work by the IMF in 2009 and 2010 (Debrun et al, I think)is comprehensive. It's a quencher; but you still have to mince through the classics Slow/Blinder back in the '70s- (not certain if GC concurs, he may have his own shelf) and Auerbach and Feldstein in the decade past. O Blandchard has been in and out. The corporate problematic ultimately addresses propensity towards effective investments and efficient production, entailing considerations of after-tax rewards and capital formation.

  6. Swells: Thanks for the IMF link!

    JL: Just to add to Swells's suggested readings, a good starting point is Prof. Blinder's paper I refer to in my subsequent post. It covers the issue of countercyclical tax/fiscal policy and provides an excellent history. OK, gotta go...must get my kid dressed up for Halloween fun at daycare!!

    1. @swells & circuit...all the above are excellent thinkers. I think Alan Blinder's '77 article is foundational.
      @JL...i look forward to your sequel.

  7. I doubt the capacity of the Weimar Republic to tax, remember that the Ruhr area was occupied by France, which led to a kind of tax strike by the German government. http://en.wikipedia.org/wiki/Occupation_of_the_Ruhr

    Once out of the box, there must also have been some genuine hyperinflation dynamics. Hjalmar Schacht managed to stop the inflation by issuing a new currency - and once inflation was stabilized he could, non-inflationary, quadruple the amount of money, presumably because people were rebuilding cash balances.

  8. it should be noted that at the time this was a major anglo-american view too. Most famously represented by Keynes in the economic consequences of the peace and later papers on reparations. harold moulton also wrote a book on the topic.

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