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) 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).
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
