Money-money-money. Part I
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German monetary history in the first half of the twentieth century.(Statistical Data Included)
From: Economic Quarterly | Date: 1/1/2002 | Author: Hetzel, Robert L.
Economic Quarterly
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At the end of 1998, the German Bundesbank turned over the administration of monetary policy to the European Central Bank (ECB). In the years between World War I and 1998, the Bundesbank had come to embody the modern central bank. What history did Germany traverse to make possible the creation of such an institution? And how does that history help us define a modern central bank?
Today, a central bank chooses one of two objectives. It may target either the exchange rate or domestic economic conditions, including the inflation rate. In either case, the central bank is the unique institution charged with controlling the chosen objective. Such control relies exclusively on the central bank's management of its own balance sheet. In particular, the central bank controls its liabilities (the monetary base) through its asset acquisition. (1)
Conversely, a country with a modern central bank does not rely on government intervention in specific markets to achieve either price-level or exchange-rate objectives. If the central bank targets the exchange rate, the country does not rely on exchange controls, multiple exchange rates, tariffs, quotas, or other administrative measures. If the central bank targets the inflation rate, the country does not rely on wage and price controls, guideposts, antitrust actions, or special intervention into the wage and price-setting decisions of firms. A modern central bank does not in general allocate credit either through subsidized lending at the discount window or quotas on the credit that individual banks can extend.
This article reviews German monetary history in the first half of the twentieth century, employing the theme that the evolution of the concept of a modern central bank required popular support for a free market. (2) It summarizes three episodes: hyperinflation in the twenties, deflation in the early thirties, and the currency reform of 1948. Inflation and deflation accompanied the economic instability of the first and second episodes, respectively. In each case, free enterprise lost public support. The third episode inaugurated a period of economic and monetary stability, during which free enterprise again became acceptable.
1. HYPERINFLATION IN THE WEIMAR REPUBLIC
In 1913, total currency in Germany amounted to just 6 billion marks. In November 1923 in Berlin, a loaf of bread cost 428 billion marks and a kilogram of butter almost 6,000 billion marks. From the end of World War I until 1924, the price level rose almost one trillionfold. (3) The economic cause of this hyperinflation was the monetization of public and private debt by Germany's central bank, the Reichsbank. (4) The political cause lay in the inability of a fragile democracy to impose the taxes necessary to pay war reparations. (5)
Reparations and Budget Deficits
Germany entered World War I believing that the war would be like the Franco-Prussian War of 1870-1871 and that the government would be able to finance a short war by issuing bonds, which a defeated France would redeem in gold (Marsh 1992, 77). In fact, the combatants devoted half of their economic output to the fighting. The central government in Germany, which did not impose income taxes, financed the war almost completely by issuing debt. With the deficits that followed the end of the war, the Reich's debt amounted to half of national wealth. Interest on the debt amounted to four times the Reich's 1913 revenues. (6)
At Versailles, the victorious Allies imposed a punitive settlement on Germany. They stripped Germany of its colonies and Alsace-Lorraine. The Versailles treaty required that Germany pay for the damages caused by the war without stipulating an upper limit. France in particular demanded heavy reparations, embittered by the appalling human cost of retaking Alsace-Lorraine.
In May 1921, in the London Ultimatum, the Allies set an aggregate amount for reparations of 132 billion gold marks. However, the Ultimatum allowed the Reparations Commission to demand interest on the unpaid amount when it judged that German finances had recovered. Uncertainty about the total reparations payments and the disincentive to run fiscal surpluses that uncertainty created for Germany probably weighed even more heavily than the huge magnitude of the total. Foreign lenders then found it difficult to assess Germany's credit worthiness (Holtfrerich 1986, 143, 145, 154).
Because of differing valuations placed on payments in kind, it is difficult to measure the reparations Germany actually paid. Holtfrerich (1986, 151) compares various estimates and concludes that for the years 1919 through 1922, Germany paid 10 percent of its national income in reparations. Webb (1989, 106) arrives at a similar number, which amounted to 80 percent of Germany's exports. Holtfrerich (1986, 153) points out that, as a fraction of national income, reparations equalled the amount of government expenditure at all levels in the prewar period.
Holtfrerich (1986, 153) argues that Germany could not have raised through direct taxation the amounts necessary "to effect a foreign transfer regarded from the outset as beyond fulfillment, unjust and indeed morally reprehensible by almost the entire population." He explains the resort to an inflation tax by quoting Friedrich Bendixen, a Hamburg bank director:
Only in taxation do people discern the arbitrary incursions of the state; the movement of prices, on the other hand, seems to them sometimes the outcome of traders' sordid machinations, more often a dispensation which, like frost and hail, mankind must simply accept. The statesman's opportunity lies in appreciating this mental disposition. (153)
Unable to cover its expenditures through explicit taxes, the German government ran deficits exceeding 50 percent of its expenditures from 1919 through 1923 (Holtfrerich 1986, 173). Reichsbank purchases of government debt made the printing press the ultimate source for funding these deficits. (7)
Holtfrerich (1986, 152) reproduces figures of Arnd Jessen showing that, as a proportion of government expenditures, the yield of the inflation tax also amounted to about 50 percent. In the years 1919, 1920, 1921, and 1922, revenue from the inflation tax respectively amounted to 62, 53, 43, and 43 percent of government revenue.
A Chronology of Inflation
Although money creation ultimately caused German inflation, expectations about the ability of the government to achieve ultimate fiscal balance determined inflation's timing (Webb 1989). The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits. When it did not, the debt presented to the Reichsbank rose. Foreign speculative capital inflows ceased, the exchange rate depreciated, and inflation rose.
Inflation exacerbated the government deficit by reducing tax revenue. Because the government levied taxes in nominal terms, the elapsed time between assessment and collection destroyed their real value (Bresciani-Turroni 1937, 66; Sargent 1993, 69). Figure 1 reveals the pattern of an inflation driven by fiscal fears. It shows the wholesale price index with the periods demarcated as by Webb (1989, 5).
At the end of the war, the fiscal situation was gloomy. In November 1918, a worker revolution overthrew the Kaisertum. Widespread, paralyzing strikes occurred. The new government issued debt to obtain the food supplies and funds for demobilization that were necessary to limit social unrest (Marsh 1992, 79). The government subsidized food, coal, and employment in the railway and postal systems to prevent a second worker revolt.
The new government's concern was valid, for it was indeed possible that fiscal restraint would raise unemployment and set off a Bolshevik revolution (Ferguson and Granville 2000, 1063--65; James 1999, 18). The price level rose from the end of the war until early 1920. By February 1920, the wholesale price level had risen to 17 times its 1913 level. According to Webb (1989, 52), this rise reduced the real value of the nominal government debt outstanding in October 1919 (172 billion marks) to a value consistent with future budget balance. The political situation stabilized in March 1920 with the failure of the Kapp Putsch.
The price level steadied after March 1920. (8) Minister of Finance Matthias Erzberger implemented tax reforms that brought Germany close to achieving future budget balance. Although the budget remained in deficit, tax revenues were rising steadily. Given stable real expenditures, growth in the economy would have increased revenues and balanced the budget. These calculations depended upon maintenance of the current level of reparations, which amounted to 2.24 billion marks in the 12-month period ending 21 June 1920.
However, in the London Schedule of May 1921, the Allies threatened to occupy the Ruhr unless Germany transferred 4 billion marks annually and made additional payments as its economy grew. The Reichstag refused to impose additional taxes, and inflation rose when the prospect of ultimate budget balance receded. As inflation rose, collection lags in the tax system reduced real revenues. In October 1921, the Allies further weakened the political standing of the German government by annexing Upper Silesia to Poland.
Only the United States was in a position to broker a compromise, for it could have forgiven war debts owed it by France and Britain in return for moderation of their reparations demands. But the United States retreated into isolationism. Contradictorily, Allied governments made it hard for Germany to run the surplus on its external trade account that was necessary to pay reparations by imposing high duties on its exports. Many Germans adopted the fatalistic attitude that German economic ruin would be necessary to demonstrate the injustice of reparations. They contended that only when the Allies scaled back demands for reparations could Germany bring order to its domestic finances.
To support their case, they argued that the reparations caused inflation: The purchase of foreign exchange to make reparations payments depreciated the mark. (9) In turn, the depreciation of the mark raised internal prices. An end to the monetization of government debt without a settlement of the reparations issue would leave unchecked both the depreciation of the mark and domestic inflation. Because the government would still have to maintain subsidies, it would become bankrupt. Rudolf von Havenstein, the head of the Reichsbank, said, "So long as the reparations burden remains, there is no other means to procure the necessary means for the Reich than the discounting of Reich Treasury notes at the Reichsbank" (Feldman 1997, 445). (10)
Inflation became hyperinflation with the assassination of foreign minister Walther Rathenau in July 1922 by right-wing reactionaries. Capital flight spurred mark depreciation, which exacerbated domestic price increases. The resulting fall in the purchasing power of the mark created a liquidity crisis. To deal with this crisis; industrialists argued for the rediscounting of bills of exchange at the Reichsbank. Georg Bernhard, an influential newspaper editor and member of the Reich Economic Council, argued that "There is only one source of money in Germany left, the Reichsbank.... It is thus absolutely correct that we create commercial bills; then the Reichsbank can issue money" (Feldman 1927, 450). In the second half of 1922, the Reichsbank began to discount significant numbers of private bills (Webb 1989, 28).
Karl Heliferich, finance minister during World War I, said that if the Reichsbank ceased "the printing of notes... all national and economic life would be stopped." (11) Hjalmar Schacht (1927), later the Reichsbank president, wrote:
In 1923 there were engaged on the production of notes for the Reichsbank...1,783 machines.... [E]ven with assistance on so vast a scale the Bank was not in a position to supply the business world with a sufficiency of notes. (105)
In fact, the high rate of inflation made holding money extraordinarily costly. German moneyholders responded rationally by reducing the real amount of marks they held. (12) The minimal real purchasing power of marks made money appear scarce. That scarcity rationalized the demands of the industrial class for the Reichsbank to continue discounting its commercial paper at a discount rate of 6 percent. In this way, industralists obtained costlessly the revenues from the taxing powers (seigniorage) that money creation granted to a central bank.
France never confronted the inherent contradictions in its policy toward Germany. It wanted a weak German economy incapable of supporting remilitarization, and it wanted the payment of reparations, which required a strong German economy. On 11 January 1923, France occupied the Ruhr when Germany failed to make in kind deliveries of coal. Germany responded with a policy of passive resistance. With government support, workers in the Ruhr went on strike to prevent France from obtaining the region's coal and steel.
Without coal, German railroads could not run, and without railroads the German economy could not run. Figure 2 shows the decline in output precipitated by the Ruhr occupation. Germany had to import coal. The government also had to pay striking workers, in part, it believed, to prevent them from joining the Communist movement and starting a Bolshevik revolution. As the government deficit widened to 22 percent of net national product, the money stock soared (Ferguson and Granville 2000, 1068). (13) By year-end 1922, the mark-dollar exchange rate had fallen from its prewar level of 4.2 to 1 to 1,500 to 1. By the end of November 1923, it had fallen to 4,200,000,000,000 to 1.
End of the Hyperinflation
On 20 November 1923, Germany ended inflation by pegging the mark's foreign exchange value at its prevailing value of 4,200 billion marks to the dollar. (14) What made monetary reform credible to the German public?
As background, note a characteristic of twentieth-century monetary reforms that ended hyperinflations (for example, in Argentina in 1991). (15) At the time of a reform, the economy in question is using a stable currency as the standard of value, often the dollar, rather than the domestic currency. In hyperinflations, individuals set prices in dollars and then use the dollar exchange rate to convert prices to domestic currency equivalents. The domestic money serves only as a token currency for small transactions. One prerequisite for a successful monetary reform is to make credible the maintenance of a fixed dollar exchange rate, which will reestablish individuals' faith in the purchasing power of domestic currency.
In 1923, "German society was moving massively to disown the paper mark" (Feldman 1997, 691). The German economy largely indexed ("valorized") transactions to maintain their real value. One example was a bank proposed by Hans Luther and Rudolf Hilferding (Food and Finance Ministers, respectively) that would issue a "rye" mark, that is, a deposit redeemable in rye. The bank came into existence on 15 November 1923 as the Rentenbank, but with a rentenmark deposit convertible to gold at the prewar value. The new bank had strict limits on the credit it could extend to the private sector and to the government and met with "astounding success" (Holtfrerich 1986, 316).
The actual breakdown of German economic life came about because of interventions by the German government to maintain the paper mark as the medium of exchange. Holtfrerich (1986, 313) writes of hyperinflation Germany, "The economy had already largely turned over to a foreign, hardcurrency standard.... The crisis arose out of the reluctance of the Reich to permit business to employ foreign means of payment in domestic transactions as desired; indeed the Reich could not permit the practice...as long as inflation remained as a 'tax' source."
Although the government ignored the price setting of the large industrial cartels, it imposed price controls on professionals and the retail trades to prevent "profiteering." Rent control destroyed the wealth of small property owners. Because farmers could not borrow using an indexed value of land as collateral, they could not obtain fertilizer (Feldman 1997, 681-84). "Because the farmers were already refusing to accept the currency... Germany faced the imminent danger of hunger revolts" (Feldman 1997, 693).
Bresciani-Turroni offers two observations helpful for understanding the German reform. First, "At the beginning of the inflation... the public still did not understand the phenomenon of monetary depreciation" (BrescianiTurroni 1937. 430). However, by the end, the public associated inflation with the money issues of the Reichsbank. Everyone knew at that point that an end to inflation would require the Reichsbank to limit monetary emission to whatever was needed to maintain the new mark-dollar exchange rate. Second, hyperinflation threatened imminent economic and social collapse. Holtfrerich (1986, 312), citing Schacht, writes "Plundering and riots were a daily occurrence," and Bresciani-Turroni (1937, 336) cites Luther, "The effective starving of the towns and the impossibility of continuing economic activities on the basis of the paper mark was so obvious in the days preceding November 16th that a dissolution of the social order must have been expected almost from hour to hour."
The 1923 reform worked because there was political consensus that it had to work. The economic disruption produced by the combination of hyperinflation and government attempts to force continued use of the mark had pushed Germany to the edge of social disintegration. Revolts, including Hitler's beerhall Putsch and attempted March on Berlin on 9 November 1923, challenged the survival of the government. A social and political consensus emerged that the Reichsbank had to maintain the dollar-mark exchange rate. Faced with chaos, Germany took steps to restore order.
In this changed environment, the Reichsbank ceased monetizing government debt. The amount of teasury bills held by the Reichsbank went from 190,000,000 trillion marks in mid-November to zero by year-end (Marsh 1992, 83). Finance minister Hans Luther balanced the budget through emergency tax decrees and budget cuts. Germany declared an end to the policy of passive resistance opposing the Ruhr occupation and ceased payments to striking workers in the Ruhr. Negotiations between Germany and the Allies began that led to the 1924 Dawes Plan rescheduling of reparations (Ferguson and Granville 2000, 1078; Yeager 1981, 57).
The final test that established the credibility of the Reichsbank occurred in April 1924. When the dollar value of the mark weakened, the Reichsbank drastically restricted credit. S. Parker Gilbert, Agent General for Reparations Payments, later cabled George Harrison, governor of the Federal Reserve Bank of New York: (16)
[The Reichsbank's] policy resulted in [a] check to [the] increase of Reichsbank credit and circulation, development of excess of exports over imports, liquidation of heavy commodity stocks accumulated during inflation, decline in commodity prices, and large failures of many firms established during inflation. Rates for month[ly] money rose from 30 to 80 percent but later declined rapidly.
Discrediting Capitalism
Ferguson and Granville (2000, 1084) write, "By discrediting free markets, the rule of law, parliamentary institutions, and international economic openness, the Weimar inflation proved the perfect seedbed for national(ist) socialism." The Weimar inflation produced arbitrary redistributions of income that discredited the market economy. As a class, the wealthy were the main losers because they held most of the mark-denominated financial wealth. Pensioners, bondholders, and rentiers lost everything. Laws against indexation and profiteering hurt merchants. Workers who were protected by labor unions preserved their real wages. (17)
Keynes has described how inflation destroys the social foundation of a market economy:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some....Those to whom the system brings windfalls...become profiteers. (1919, 148-49)
To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards. (1923, 24)
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose....By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract...governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century. (1919, 149-50)
Popular resentment concentrated on speculators. When Germans sold their family heirlooms to survive, they blamed the middlemen who organized the sales. A fictional character called Raffke, created by cabaret songwriter Kart Tucholsky, embodied the culturally ignorant person made rich from profiteering (Feldman 1997, 553). Bresciani-Turroni (1937, 328) would later write of "the poverty of certain German classes during the inflation which contrasted with the foolish extravagance and provocative ostentation of inflation profiteers."
Nationalist resentment targeted all foreigners but most especially the minority within reach--Jews. Hitler railed against the "Jewification of the economy" (Feldman 1997, 780, 575). On 5 November 1923, the government raised the price of bread to 140 billion marks, and in response, crowds plundered stores and attacked Jews. In July 1922, the British Consul in Frankfurt wrote:
[T]he educated classes, deprived, in a great majority of cases, of the right to live and bring up their families in decency, are becoming more and more hostile to the Republic and open in their adhesion to the forces of reaction. Coupled with this movement, a strong and virulent growth of anti-Semitism is manifest. (Feldman 1997, 449)
Germans wanted a world where wealth resulted from hard work, not financial transactions. According to Feldman (1997), Germans desired a return to a world where
the public good should take precedence over private gain....It was not only Hitler who appealed to these sentiments....[I]nflation...caused the Republic to be identified with...violations of law, equity and good faith....No less offensive...was the sense that there had been a misappropriation of spiritual values. (657-58)
2. WORLD DEPRESSION
Germany ended hyperinflation and restored social order with its commitment to the gold standard. The November 1923 stabilization program committed Germany to exchange 1,392 reichsmarks for a pound of gold. However, German economic stability then became dependent upon the stability of the international gold standard. Starting in 1928, the deflationary monetary policies of two of the largest adherents to the gold standard, France and the United States, forced deflation and economic depression on Germany. Short-run salvation led to longer-run doom. The following section explains the fragility of the reconstructed gold standard.
Reviving the International Gold Standard
In 1920, Britain legislated a return to the gold standard at the prewar parity to take effect at the end of a five-year period. Britain based its decision in part on the assumption that gold flows to the United States would raise price levels there and limit the domestic deflation needed to reestablish the prewar parity (Rothbard 1996, 8). In fact, the United States sterilized gold inflows to prevent a rise in domestic prices. In the 1920s, the Federal Reserve held almost twice the amount of gold required to back its note issue (Yeager 1976, 333). Britain then had to deflate to return to gold at the prewar parity. (18)
After the war, France had counted unrealistically on German reparations to balance its budget. When they did not materialize, it used inflation as a tax to finance expenditures. In 1926, France pulled back from the brink of hyperinflation. Unlike Britain, in France inflation had put the old parity hopelessly out of reach. As a consequence, France returned to gold at a parity that undervalued the franc. Scarred by its experience with inflation, France sterilized gold inflows to prevent a rise in prices.
Allied war debts and reparations added to the inherent fragility of an international gold standard programmed for deflation. They required the transfer of resources from Germany to France and England and then from these countries to the United States. To accomplish these transfers, Germany would have had to run a trade surplus toward France and Britain. In turn, France and Britain would have had to run a trade surplus toward the United States. In the protectionist environment of the 1920s, that trade pattern was politically unacceptable. Only capital outflows from the United States made the system work (Yeager 1976, 333; Holtfrerich 1989, 151). (19)
World Deflation
By the end of 1927, it appeared that Europe had successfully returned to the gold standard. However, in 1928, the Federal Reserve initiated a restrictive monetary policy to stop stock market speculation. In 1920 and 1921, a floating exchange rate had insulated Germany from deflationary U.S. monetary policy. In those years, German industrial production rose 46 and 20 percent, respectively. In contrast, in Britain, whose commitment to return to the gold standard at the prewar parity overvalued its exchange rate, industrial production fell 32 percent in 1920. (20) At the end of the decade, a revived international gold standard transmitted U.S. deflation to Germany.
In the 1920s, capital had flowed into Germany. That is, Germany exported not only goods, but also IOUs. When the Federal Reserve System began raising interest rates in 1928, those capital inflows lessened. Germany then could not use funds gained from capital inflows to pay its reparations, but instead had to run a trade surplus to gain the needed funds. The price level in Germany had to fall to make its exports more attractive to the rest of the world. By the last half of 1929, foreign debt issued in New York was less than a third of its 1927 level (Chandler 1958, 456). "Net portfolio lending by the United States declined from more than $1000 million in 1927 to less than $700 million in 1928 and turned negative in 1929" (Eichengreen 1995, 226). (21)
As a result, in 1928 U.S. financial markets began attracting gold from Europe. (22) Foreign central banks had to raise their domestic interest rates to offset gold losses. The Federal Reserve Bulletin (November 1930, 655) talked about "Money rates abroad, which had been kept up largely to protect the reserves of foreign countries against the attraction of speculative and high-money conditions in the United States." George Harrison, governor of the Federal Reserve Bank of New York, informed Secretary of the Treasury Andrew Mellon that "our high money rates... continue to act as a pressure upon all the European bank reserves." (23) At the same time, France, with its undervalued franc, also absorbed gold from the rest of the world. In 1928 and the first half of 1929, France absorbed 3 percent of global gold reserves (Eichengreen 1995, 216).
To reverse their gold outflows, other countries had to run a trade surplus with the United States and France. Because the Fed and the Banque de France sterilized gold inflows, those other countries had to achieve trade surpluses through deflation. That is, to make their goods cheaper on international markets, their price levels had to fall. By creating obstacles to trade, protectionism exacerbated the extent of the required deflation. (24) The gold standard became an engine of worldwide deflation. The most visible signs of the stress of deflation were financial panic and widespread bank failures as depositors withdrew gold and currency from banks.
Both international and domestic considerations compelled Germany to deflate rather than abandon the gold standard. The Banking Act, created in 1924 as part of the Dawes reparations plan, required Germany to back its currency with gold and foreign exchange reserves equal to 40 percent of its currency. A foreign member of the General Council, set up to oversee the Reichsbank, could stop note issue if he believed gold convertibility was threatened (James 1999, 25).
The foreign loans from the Morgan syndicate required Germany to stay on gold. Those loans allowed Germany to finance its reparations payments. Germany also believed that adherence to the gold standard would provide it with a reputation for financial conservatism that would make credible its efforts to renegotiate reparations obligations. Finally, and most important, seared by the memory of hyperinflation, German public opinion supported the gold standard. Germans associated abandonment of the gold standard with inflation (Bresciani-Turroni 1937, 402; Eichengreen 1995, 270; James 1999, 25). Politicians had difficulty supporting a possibly inflationary policy without appearing to favor large industry and agriculture, which as debtors had profited from the earlier inflation (Feldman 1997, 853).
The 1931 German Financial Panic
As noted above, the Reichsbank had to maintain at least a 40 percent gold cover, that is, a gold-reserves-to-note circulation ratio of 40 percent. In April 1929, with the near collapse of reparations negotiations in Paris, reserve outflows threatened the gold cover. In May 1929, the successful resumption of the negotiations reestablished calm and led to the Young Plan, signed in June. In September1930, when elections gave Hitler's party the second largest majority in the Reichstag, gold outflows from the Reichsbank resumed; aid from an international consortium relieved the crisis. In May 1931, the gold cover had risen to a comfortable 60 percent. (25)
Any lasting restoration of investor confidence in the mark's gold parity would require settlement of the reparations issue. (26) Investors worried whether Germany could finance reparations payments in the absence of continued capital inflows. They also worried about the political instability within Germany caused by reparations. Right-wing parties demanded that Germany renounce reparations. The Bruening government had been unable to form a parliamentary majority since July 1930. Chancellor Bruening dismissed the Reichstag and governed without it.
At the beginning of June 1931, the Reichsbank again began to lose gold. (27) This worsening in the German balance of payments ultimately occurred at this time because the deflationary pressure of U.S. monetary policy intensified. The U.S. money stock M2 had declined only 2 percent in 1930. In 1931Q1 and 193 1Q2, it fell at an annualized rate of 6.3 and 6.7 percent, respectively. In 193 1Q3, M2 declined at an annualized rate of 11.3 percent (Friedman and Schwartz 1963). (28)
Bank failures in Austria and Hungary were the immediate source of the financial panic in Germany. The first of these was the failure of the Austrian Credit-Anstalt bank in mid-May 1931, after which Austria suspended gold convertibility and allowed its currency to depreciate. Because foreigners held half of German bank deposits, financial stability required that foreign investors retain confidence in the maintenance by Germany of its gold parity (Eichengreen 1995, 272). Only American leadership could have achieved that result.
On 20 June 1931, President Hoover proposed a one-year moratorium on reparations and Allied debt payments. Financial markets worldwide responded positively (Eichengreen 1995, 277). However, French ill will toward Germany delayed the negotiations until a debt moratorium was too late to help. French reluctance to agree to the Hoover moratorium made investors nervous. That nervousness caused the financial panics in Austria and Hungary to jump the border to Germany. (29)
The appendix, "The Federal Reserve Bank of New York and the Reichsbank during the 1931 Crisis," provides an account of these events recorded in memos by Governor Harrison of the New York Fed. Central banks had cooperated to maintain the gold standard in the twenties. Walter Bagehot, a British economist, had expounded the lender-of-last-resort principle of lending freely at a high interest rate in a financial crisis (Bagehot 1873). These precedents suggested that the New York Fed, the Bank of England, and the Banque de France would lend to the Reichsbank. Had they done so, it is possible that monetary contraction and the fall in the German price level necessary to improve Germany's trade balance could have occurred in an orderly fashion. However, as a condition for a loan, the New York Fed required that the Bundesbank cease lending to commercial banks. The Reichsbank's compliance precipitated the collapse of its banking system, and the New York Fed then failed to come through with a loan.
Between 1926 and 1932, the Reichsbank maintained short-term interest rates at around 6 percent (Figure 3). (30) Figure 4 shows that significant deflation began in 1929 and continued through 1932. Despite this deflation, the Reichsbank kept market interest rates high. Table 1 shows the realized real rate of interest -- the market rate minus actual inflation. This series rose moderately through 1929 and dramatically in the years 1930, 1931, and 1932. (31)
Monetary contraction allowed the Reichsbank to maintain high real rates of interest. Given the stability of monetary velocity (Figure 3), monetary contraction required a decline in nominal output (Figure 5). (32) Real output peaked in 1928 and then fell 16 percent through 1932. Only in 1933 did output begin a modest recovery (Figure 6 and Table 2). (33)
Discrediting Capitalism
Given its adherence to the gold standard, Germany had to prevent capital outflows to avoid deflation and use fiscal authority to persuade international creditors of its credit worthiness. As German recession deepened, the government cut the social programs instituted after the war. The public therefore associated the market discipline of capitalism with government neglect of social needs. (34)
"The Reichsbank thus succeeded in cutting back the social programs started after the [1918] revolution.... The public perceived a dramatic failure of free market capitalism. They fell all the harder for the economic populism of the National Socialists" (Webb 1989, 127). Capitalism in the twentieth century did not appear to be a system that enriched the masses. Instead, it appeared to be a system that allowed the strong to exploit the weak. The depression discredited capitalism.
Harold James (1986) writes:
It was the outbreak of the banking crisis in the summer of 1931 that made the German depression so severe....[T]he collapse of the banks in central Europe had a major social, psychological and political impact. Capitalism appeared to have crashed with the banks, and this helped to discredit existing political systems. (283-84)
The years following the 1923 stabilization had offered the promise of a return to stability. The Young Plan for German reparations, adopted in principle at The Hague in August 1929, promised an end to reparations in 1988. Right-wing German parties rejected reparations and the "war guilt lie" they represented (Nicholls 1968, 137). Nevertheless, in early 1930 these parties, including the Nazi party, were marginal. Their marginal status changed with the spread of the depression. Under the stress of the deflation that began in 1929, Germany could not keep together a political coalition capable of maintaining the democratic institutions of the Weimar Republic. Hitler was the clear beneficiary of the nationalist resentments revived by rising unemployment. (35) The unemployment rate averaged 28.1 percent in 1932 (Table 2). Hitler became chancellor of the government in January 1933. (36)
When Hitler came to power, the Reichsbank began to discount bills to finance his public works and rearmament program. In 1936, Hitler imposed a price freeze to control inflation. He said, "Inflation is a lack of discipline......... I'll see to it that prices remain stable. That's what my storm troopers are for" (Feldman 1997, 855). And again, "The first cause of the stability of the currency is the concentration camp" (James 1999, 35). Schacht, who became Reichsbank president for the second time in March 1933, maintained the mark price of gold by imposing foreign exchange controls and barter arrangements for foreign trade. "Germans who settled foreign debts directly with their creditors were threatened with the death penalty" (Pringle 1998, 71). Germans rejected the arbitrary redistribution of wealth produced by hyperinflation and the unemployment produced by deflation. With the discrediting of capitalism, they turned to monetary arrangements that required the detailed control of individual behavior by the st ate.
3. THE BIRTH OF THE D-MARK
Once capital controls effectively ended the gold standard, the Reichsbank was able to finance Germany's rearmament and war expenditures by printing money. Price controls created suppressed inflation. After the war ended, the Allied occupation forces maintained the price controls, and inflation continued to be suppressed.
The currency reform of 1948 ended price controls and introduced the deutsche mark (DM). The ensuing period of strong economic growth (the Wirtschaftswunder) and the resulting monetary stability contrasted with the hyperinflation and subsequent deflation of the Weimar Republic. That contrast bred the presumption that economic and social stability required monetary stability, and this widespread presumption later created popular support for the "stability" policy of the Bundesbank.
Price Controls and Suppressed Inflation
Despite the devastation of World War II, Germany was in a position to recover economically after the war. Buchheim (1999) writes:
The conditions for resuming production in western Germany were actually very good. Despite the war dead, the influx of refugees and expellees saw a sharp rise in the general population....[M]any of the newcomers had been employed in industrial production occupations and had the appropriate skills....[N]ew investments during the war had far exceeded the plant facilities destroyed. For this reason, West German industrial assets in 1945 were not only greater than before the war, but also more modern. (57-58) (37)
However, in 1947, two years after the end of the war, industrial production in Germany amounted to only 40 percent of its 1936 level. Price controls throttled German economic recovery. In other Western European countries, which also suffered war damage but did not have price controls, output exceeded the prewar level by 1947 (Yeager 1976, 388).
From 1936 through 1944, money (measured by currency in circulation plus total bank deposits) rose somewhat more than sixfold (Table 2). Despite this rise in money, price controls restrained the rise in the official consumer price index to only 14 percent from 1936 through 1944. Germany therefore ended the war with suppressed inflation. The Allies kept Hitler's price freeze in effect during the postwar occupation. Goods traded on the black market or through barter because no one wanted to exchange goods for marks at the artificially low price level. (38)
Germans used nylon stockings, American cigarettes, and Parker pens for currency. For example, in 1945, ten cigarettes could be exchanged for 1,500 grams of bread and two pairs of stockings for 1.5 pounds of butter (Haus der Geschichte). (39) American soldiers could obtain those items from the PX. Germans resented the privileges that this commodity money gave Americans. General Clay, the American military governor, responded to this resentment by strictly enforcing the law against black market transactions (Smyser 1999, 44).
Allied enforcement of price controls paralyzed the German economy. For example, farmers would not bring crops to market. Children died of malnourishment and food riots broke out (Smyser 1999, 31-32). Controls discouraged work effort. With little effort, workers could earn enough marks to buy all the rations allowed them by their ration cards. At the same time, the artificially low wage rates did not permit workers to work long enough to buy the goods that were available at black market prices (Buchheim 1999, 60; Haus der Geschichte).
Paradoxically, the depressing effect of the controls on economic activity seemed to assure their survival. Germans overwhelmingly saw the end of controls as relinquishing the certain for a frightening uncertainty. Most believed that the disappearance of the ration cards and the minimum of sustenance that they assured would push the impoverished over the line into destitution (Bark and Gress 1989, 197).
Currency Reform
By early 1947, U.S. Secretary of State George Marshall understood fully the desperate condition of Europe. He had come to believe that Stalin would not accept a unified Germany except under Russian control. Marshall and Ernest Bevin, the British foreign minister, concluded that the West had to reconstruct Germany without the Soviet Union (Smyser 1989, 55-56). On 5 June 1947, Marshall proposed what later became known as the Marshall Plan. The United States wanted an economically viable Western Europe, which required a prosperous Germany. Currency reform was a vital ingredient of economic reconstruction. Germany needed a universally accepted currency to be able to trade freely both within and across its borders.
The American economic advisers to General Clay prepared a plan for currency reform based on reforms in Russia and Czechoslovakia (Clay 1950, 209). The reform preserved the relatively low level of controlled prices by converting wage rates and pension payments one-for-one from reichsmarks to the new DMs. However, it eliminated the monetary overhang inherited from the Third Reich by limiting the quantity of reichsmarks that could be exchanged for DMs. Under the terms of the reform, which came into effect 20 June 1948, West Germans could turn in 60 reichsmarks on a one-to-one basis. Further exchanges occurred at a ratio of ten to one. The monetary authority converted assets and savings deposits at a sharply reduced rate. (40)
Clay (1950, 210) feared that the reform would favor the German "trend toward socialism" by destroying the financial "savings of the little man" while rewarding the "black market operators who had invested their huge gains in real estate." Therefore, the original plan included provisions for a capital levy to compensate the losers from the ten-to-one write-down of the reichsmark. However, Marshall insisted on limiting the reform to the currency exchange.
The German economic miracle began with the currency reform of June 1948. When the currency reform was announced, Ludwig Erhard, economic director of the joint American-British Bizonal Economic Administration, decreed the end of price controls. The day the price controls ended, goods returned to store shelves. With the end of controls, "euphoria engulfed most Germans at the sight of goods and food items they could only dream about in the past. Bakeries miraculously produced and displayed delicious cakes; vegetables, butter and eggs appeared in abundance" (Bark and Gress 1989, 201).
Industrial production in West Germany rose 25 percent within two months and 50 percent within six months (Buchheim 1993, 72; Marsh 1992, 173). With prices that made crops worth selling, West Germany a gain had enough food (Smyser 1999, 50). From 1948 through 1950, GDP growth in Germany remained above 15 percent per year. In the 1950s, Germany grew at an average annualized rate of 8 percent (Giersch et al. 1992, 2, Figure 1).
Nevertheless, immediately after their introduction, the fate of the Erhard reforms remained in question. The currency reform carried the opprobrium of destroying the financial wealth of ordinary Germans while enhancing the tangible wealth of those holding productive capital. It thus restored the industrialists' economic position, which had created envy in the Weimar Republic and Third Reich. Many Germans wanted a reintroduction of price controls, believing they would make basic goods and food affordable. In November 1948, more than 9 million German workers engaged in a general strike (Merkl 1963, 107).
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German monetary history in the first half of the twentieth century.(Statistical Data Included)
From: Economic Quarterly | Date: 1/1/2002 | Author: Hetzel, Robert L.
Economic Quarterly
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At the end of 1998, the German Bundesbank turned over the administration of monetary policy to the European Central Bank (ECB). In the years between World War I and 1998, the Bundesbank had come to embody the modern central bank. What history did Germany traverse to make possible the creation of such an institution? And how does that history help us define a modern central bank?
Today, a central bank chooses one of two objectives. It may target either the exchange rate or domestic economic conditions, including the inflation rate. In either case, the central bank is the unique institution charged with controlling the chosen objective. Such control relies exclusively on the central bank's management of its own balance sheet. In particular, the central bank controls its liabilities (the monetary base) through its asset acquisition. (1)
Conversely, a country with a modern central bank does not rely on government intervention in specific markets to achieve either price-level or exchange-rate objectives. If the central bank targets the exchange rate, the country does not rely on exchange controls, multiple exchange rates, tariffs, quotas, or other administrative measures. If the central bank targets the inflation rate, the country does not rely on wage and price controls, guideposts, antitrust actions, or special intervention into the wage and price-setting decisions of firms. A modern central bank does not in general allocate credit either through subsidized lending at the discount window or quotas on the credit that individual banks can extend.
This article reviews German monetary history in the first half of the twentieth century, employing the theme that the evolution of the concept of a modern central bank required popular support for a free market. (2) It summarizes three episodes: hyperinflation in the twenties, deflation in the early thirties, and the currency reform of 1948. Inflation and deflation accompanied the economic instability of the first and second episodes, respectively. In each case, free enterprise lost public support. The third episode inaugurated a period of economic and monetary stability, during which free enterprise again became acceptable.
1. HYPERINFLATION IN THE WEIMAR REPUBLIC
In 1913, total currency in Germany amounted to just 6 billion marks. In November 1923 in Berlin, a loaf of bread cost 428 billion marks and a kilogram of butter almost 6,000 billion marks. From the end of World War I until 1924, the price level rose almost one trillionfold. (3) The economic cause of this hyperinflation was the monetization of public and private debt by Germany's central bank, the Reichsbank. (4) The political cause lay in the inability of a fragile democracy to impose the taxes necessary to pay war reparations. (5)
Reparations and Budget Deficits
Germany entered World War I believing that the war would be like the Franco-Prussian War of 1870-1871 and that the government would be able to finance a short war by issuing bonds, which a defeated France would redeem in gold (Marsh 1992, 77). In fact, the combatants devoted half of their economic output to the fighting. The central government in Germany, which did not impose income taxes, financed the war almost completely by issuing debt. With the deficits that followed the end of the war, the Reich's debt amounted to half of national wealth. Interest on the debt amounted to four times the Reich's 1913 revenues. (6)
At Versailles, the victorious Allies imposed a punitive settlement on Germany. They stripped Germany of its colonies and Alsace-Lorraine. The Versailles treaty required that Germany pay for the damages caused by the war without stipulating an upper limit. France in particular demanded heavy reparations, embittered by the appalling human cost of retaking Alsace-Lorraine.
In May 1921, in the London Ultimatum, the Allies set an aggregate amount for reparations of 132 billion gold marks. However, the Ultimatum allowed the Reparations Commission to demand interest on the unpaid amount when it judged that German finances had recovered. Uncertainty about the total reparations payments and the disincentive to run fiscal surpluses that uncertainty created for Germany probably weighed even more heavily than the huge magnitude of the total. Foreign lenders then found it difficult to assess Germany's credit worthiness (Holtfrerich 1986, 143, 145, 154).
Because of differing valuations placed on payments in kind, it is difficult to measure the reparations Germany actually paid. Holtfrerich (1986, 151) compares various estimates and concludes that for the years 1919 through 1922, Germany paid 10 percent of its national income in reparations. Webb (1989, 106) arrives at a similar number, which amounted to 80 percent of Germany's exports. Holtfrerich (1986, 153) points out that, as a fraction of national income, reparations equalled the amount of government expenditure at all levels in the prewar period.
Holtfrerich (1986, 153) argues that Germany could not have raised through direct taxation the amounts necessary "to effect a foreign transfer regarded from the outset as beyond fulfillment, unjust and indeed morally reprehensible by almost the entire population." He explains the resort to an inflation tax by quoting Friedrich Bendixen, a Hamburg bank director:
Only in taxation do people discern the arbitrary incursions of the state; the movement of prices, on the other hand, seems to them sometimes the outcome of traders' sordid machinations, more often a dispensation which, like frost and hail, mankind must simply accept. The statesman's opportunity lies in appreciating this mental disposition. (153)
Unable to cover its expenditures through explicit taxes, the German government ran deficits exceeding 50 percent of its expenditures from 1919 through 1923 (Holtfrerich 1986, 173). Reichsbank purchases of government debt made the printing press the ultimate source for funding these deficits. (7)
Holtfrerich (1986, 152) reproduces figures of Arnd Jessen showing that, as a proportion of government expenditures, the yield of the inflation tax also amounted to about 50 percent. In the years 1919, 1920, 1921, and 1922, revenue from the inflation tax respectively amounted to 62, 53, 43, and 43 percent of government revenue.
A Chronology of Inflation
Although money creation ultimately caused German inflation, expectations about the ability of the government to achieve ultimate fiscal balance determined inflation's timing (Webb 1989). The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits. When it did not, the debt presented to the Reichsbank rose. Foreign speculative capital inflows ceased, the exchange rate depreciated, and inflation rose.
Inflation exacerbated the government deficit by reducing tax revenue. Because the government levied taxes in nominal terms, the elapsed time between assessment and collection destroyed their real value (Bresciani-Turroni 1937, 66; Sargent 1993, 69). Figure 1 reveals the pattern of an inflation driven by fiscal fears. It shows the wholesale price index with the periods demarcated as by Webb (1989, 5).
At the end of the war, the fiscal situation was gloomy. In November 1918, a worker revolution overthrew the Kaisertum. Widespread, paralyzing strikes occurred. The new government issued debt to obtain the food supplies and funds for demobilization that were necessary to limit social unrest (Marsh 1992, 79). The government subsidized food, coal, and employment in the railway and postal systems to prevent a second worker revolt.
The new government's concern was valid, for it was indeed possible that fiscal restraint would raise unemployment and set off a Bolshevik revolution (Ferguson and Granville 2000, 1063--65; James 1999, 18). The price level rose from the end of the war until early 1920. By February 1920, the wholesale price level had risen to 17 times its 1913 level. According to Webb (1989, 52), this rise reduced the real value of the nominal government debt outstanding in October 1919 (172 billion marks) to a value consistent with future budget balance. The political situation stabilized in March 1920 with the failure of the Kapp Putsch.
The price level steadied after March 1920. (8) Minister of Finance Matthias Erzberger implemented tax reforms that brought Germany close to achieving future budget balance. Although the budget remained in deficit, tax revenues were rising steadily. Given stable real expenditures, growth in the economy would have increased revenues and balanced the budget. These calculations depended upon maintenance of the current level of reparations, which amounted to 2.24 billion marks in the 12-month period ending 21 June 1920.
However, in the London Schedule of May 1921, the Allies threatened to occupy the Ruhr unless Germany transferred 4 billion marks annually and made additional payments as its economy grew. The Reichstag refused to impose additional taxes, and inflation rose when the prospect of ultimate budget balance receded. As inflation rose, collection lags in the tax system reduced real revenues. In October 1921, the Allies further weakened the political standing of the German government by annexing Upper Silesia to Poland.
Only the United States was in a position to broker a compromise, for it could have forgiven war debts owed it by France and Britain in return for moderation of their reparations demands. But the United States retreated into isolationism. Contradictorily, Allied governments made it hard for Germany to run the surplus on its external trade account that was necessary to pay reparations by imposing high duties on its exports. Many Germans adopted the fatalistic attitude that German economic ruin would be necessary to demonstrate the injustice of reparations. They contended that only when the Allies scaled back demands for reparations could Germany bring order to its domestic finances.
To support their case, they argued that the reparations caused inflation: The purchase of foreign exchange to make reparations payments depreciated the mark. (9) In turn, the depreciation of the mark raised internal prices. An end to the monetization of government debt without a settlement of the reparations issue would leave unchecked both the depreciation of the mark and domestic inflation. Because the government would still have to maintain subsidies, it would become bankrupt. Rudolf von Havenstein, the head of the Reichsbank, said, "So long as the reparations burden remains, there is no other means to procure the necessary means for the Reich than the discounting of Reich Treasury notes at the Reichsbank" (Feldman 1997, 445). (10)
Inflation became hyperinflation with the assassination of foreign minister Walther Rathenau in July 1922 by right-wing reactionaries. Capital flight spurred mark depreciation, which exacerbated domestic price increases. The resulting fall in the purchasing power of the mark created a liquidity crisis. To deal with this crisis; industrialists argued for the rediscounting of bills of exchange at the Reichsbank. Georg Bernhard, an influential newspaper editor and member of the Reich Economic Council, argued that "There is only one source of money in Germany left, the Reichsbank.... It is thus absolutely correct that we create commercial bills; then the Reichsbank can issue money" (Feldman 1927, 450). In the second half of 1922, the Reichsbank began to discount significant numbers of private bills (Webb 1989, 28).
Karl Heliferich, finance minister during World War I, said that if the Reichsbank ceased "the printing of notes... all national and economic life would be stopped." (11) Hjalmar Schacht (1927), later the Reichsbank president, wrote:
In 1923 there were engaged on the production of notes for the Reichsbank...1,783 machines.... [E]ven with assistance on so vast a scale the Bank was not in a position to supply the business world with a sufficiency of notes. (105)
In fact, the high rate of inflation made holding money extraordinarily costly. German moneyholders responded rationally by reducing the real amount of marks they held. (12) The minimal real purchasing power of marks made money appear scarce. That scarcity rationalized the demands of the industrial class for the Reichsbank to continue discounting its commercial paper at a discount rate of 6 percent. In this way, industralists obtained costlessly the revenues from the taxing powers (seigniorage) that money creation granted to a central bank.
France never confronted the inherent contradictions in its policy toward Germany. It wanted a weak German economy incapable of supporting remilitarization, and it wanted the payment of reparations, which required a strong German economy. On 11 January 1923, France occupied the Ruhr when Germany failed to make in kind deliveries of coal. Germany responded with a policy of passive resistance. With government support, workers in the Ruhr went on strike to prevent France from obtaining the region's coal and steel.
Without coal, German railroads could not run, and without railroads the German economy could not run. Figure 2 shows the decline in output precipitated by the Ruhr occupation. Germany had to import coal. The government also had to pay striking workers, in part, it believed, to prevent them from joining the Communist movement and starting a Bolshevik revolution. As the government deficit widened to 22 percent of net national product, the money stock soared (Ferguson and Granville 2000, 1068). (13) By year-end 1922, the mark-dollar exchange rate had fallen from its prewar level of 4.2 to 1 to 1,500 to 1. By the end of November 1923, it had fallen to 4,200,000,000,000 to 1.
End of the Hyperinflation
On 20 November 1923, Germany ended inflation by pegging the mark's foreign exchange value at its prevailing value of 4,200 billion marks to the dollar. (14) What made monetary reform credible to the German public?
As background, note a characteristic of twentieth-century monetary reforms that ended hyperinflations (for example, in Argentina in 1991). (15) At the time of a reform, the economy in question is using a stable currency as the standard of value, often the dollar, rather than the domestic currency. In hyperinflations, individuals set prices in dollars and then use the dollar exchange rate to convert prices to domestic currency equivalents. The domestic money serves only as a token currency for small transactions. One prerequisite for a successful monetary reform is to make credible the maintenance of a fixed dollar exchange rate, which will reestablish individuals' faith in the purchasing power of domestic currency.
In 1923, "German society was moving massively to disown the paper mark" (Feldman 1997, 691). The German economy largely indexed ("valorized") transactions to maintain their real value. One example was a bank proposed by Hans Luther and Rudolf Hilferding (Food and Finance Ministers, respectively) that would issue a "rye" mark, that is, a deposit redeemable in rye. The bank came into existence on 15 November 1923 as the Rentenbank, but with a rentenmark deposit convertible to gold at the prewar value. The new bank had strict limits on the credit it could extend to the private sector and to the government and met with "astounding success" (Holtfrerich 1986, 316).
The actual breakdown of German economic life came about because of interventions by the German government to maintain the paper mark as the medium of exchange. Holtfrerich (1986, 313) writes of hyperinflation Germany, "The economy had already largely turned over to a foreign, hardcurrency standard.... The crisis arose out of the reluctance of the Reich to permit business to employ foreign means of payment in domestic transactions as desired; indeed the Reich could not permit the practice...as long as inflation remained as a 'tax' source."
Although the government ignored the price setting of the large industrial cartels, it imposed price controls on professionals and the retail trades to prevent "profiteering." Rent control destroyed the wealth of small property owners. Because farmers could not borrow using an indexed value of land as collateral, they could not obtain fertilizer (Feldman 1997, 681-84). "Because the farmers were already refusing to accept the currency... Germany faced the imminent danger of hunger revolts" (Feldman 1997, 693).
Bresciani-Turroni offers two observations helpful for understanding the German reform. First, "At the beginning of the inflation... the public still did not understand the phenomenon of monetary depreciation" (BrescianiTurroni 1937. 430). However, by the end, the public associated inflation with the money issues of the Reichsbank. Everyone knew at that point that an end to inflation would require the Reichsbank to limit monetary emission to whatever was needed to maintain the new mark-dollar exchange rate. Second, hyperinflation threatened imminent economic and social collapse. Holtfrerich (1986, 312), citing Schacht, writes "Plundering and riots were a daily occurrence," and Bresciani-Turroni (1937, 336) cites Luther, "The effective starving of the towns and the impossibility of continuing economic activities on the basis of the paper mark was so obvious in the days preceding November 16th that a dissolution of the social order must have been expected almost from hour to hour."
The 1923 reform worked because there was political consensus that it had to work. The economic disruption produced by the combination of hyperinflation and government attempts to force continued use of the mark had pushed Germany to the edge of social disintegration. Revolts, including Hitler's beerhall Putsch and attempted March on Berlin on 9 November 1923, challenged the survival of the government. A social and political consensus emerged that the Reichsbank had to maintain the dollar-mark exchange rate. Faced with chaos, Germany took steps to restore order.
In this changed environment, the Reichsbank ceased monetizing government debt. The amount of teasury bills held by the Reichsbank went from 190,000,000 trillion marks in mid-November to zero by year-end (Marsh 1992, 83). Finance minister Hans Luther balanced the budget through emergency tax decrees and budget cuts. Germany declared an end to the policy of passive resistance opposing the Ruhr occupation and ceased payments to striking workers in the Ruhr. Negotiations between Germany and the Allies began that led to the 1924 Dawes Plan rescheduling of reparations (Ferguson and Granville 2000, 1078; Yeager 1981, 57).
The final test that established the credibility of the Reichsbank occurred in April 1924. When the dollar value of the mark weakened, the Reichsbank drastically restricted credit. S. Parker Gilbert, Agent General for Reparations Payments, later cabled George Harrison, governor of the Federal Reserve Bank of New York: (16)
[The Reichsbank's] policy resulted in [a] check to [the] increase of Reichsbank credit and circulation, development of excess of exports over imports, liquidation of heavy commodity stocks accumulated during inflation, decline in commodity prices, and large failures of many firms established during inflation. Rates for month[ly] money rose from 30 to 80 percent but later declined rapidly.
Discrediting Capitalism
Ferguson and Granville (2000, 1084) write, "By discrediting free markets, the rule of law, parliamentary institutions, and international economic openness, the Weimar inflation proved the perfect seedbed for national(ist) socialism." The Weimar inflation produced arbitrary redistributions of income that discredited the market economy. As a class, the wealthy were the main losers because they held most of the mark-denominated financial wealth. Pensioners, bondholders, and rentiers lost everything. Laws against indexation and profiteering hurt merchants. Workers who were protected by labor unions preserved their real wages. (17)
Keynes has described how inflation destroys the social foundation of a market economy:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some....Those to whom the system brings windfalls...become profiteers. (1919, 148-49)
To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards. (1923, 24)
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose....By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract...governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century. (1919, 149-50)
Popular resentment concentrated on speculators. When Germans sold their family heirlooms to survive, they blamed the middlemen who organized the sales. A fictional character called Raffke, created by cabaret songwriter Kart Tucholsky, embodied the culturally ignorant person made rich from profiteering (Feldman 1997, 553). Bresciani-Turroni (1937, 328) would later write of "the poverty of certain German classes during the inflation which contrasted with the foolish extravagance and provocative ostentation of inflation profiteers."
Nationalist resentment targeted all foreigners but most especially the minority within reach--Jews. Hitler railed against the "Jewification of the economy" (Feldman 1997, 780, 575). On 5 November 1923, the government raised the price of bread to 140 billion marks, and in response, crowds plundered stores and attacked Jews. In July 1922, the British Consul in Frankfurt wrote:
[T]he educated classes, deprived, in a great majority of cases, of the right to live and bring up their families in decency, are becoming more and more hostile to the Republic and open in their adhesion to the forces of reaction. Coupled with this movement, a strong and virulent growth of anti-Semitism is manifest. (Feldman 1997, 449)
Germans wanted a world where wealth resulted from hard work, not financial transactions. According to Feldman (1997), Germans desired a return to a world where
the public good should take precedence over private gain....It was not only Hitler who appealed to these sentiments....[I]nflation...caused the Republic to be identified with...violations of law, equity and good faith....No less offensive...was the sense that there had been a misappropriation of spiritual values. (657-58)
2. WORLD DEPRESSION
Germany ended hyperinflation and restored social order with its commitment to the gold standard. The November 1923 stabilization program committed Germany to exchange 1,392 reichsmarks for a pound of gold. However, German economic stability then became dependent upon the stability of the international gold standard. Starting in 1928, the deflationary monetary policies of two of the largest adherents to the gold standard, France and the United States, forced deflation and economic depression on Germany. Short-run salvation led to longer-run doom. The following section explains the fragility of the reconstructed gold standard.
Reviving the International Gold Standard
In 1920, Britain legislated a return to the gold standard at the prewar parity to take effect at the end of a five-year period. Britain based its decision in part on the assumption that gold flows to the United States would raise price levels there and limit the domestic deflation needed to reestablish the prewar parity (Rothbard 1996, 8). In fact, the United States sterilized gold inflows to prevent a rise in domestic prices. In the 1920s, the Federal Reserve held almost twice the amount of gold required to back its note issue (Yeager 1976, 333). Britain then had to deflate to return to gold at the prewar parity. (18)
After the war, France had counted unrealistically on German reparations to balance its budget. When they did not materialize, it used inflation as a tax to finance expenditures. In 1926, France pulled back from the brink of hyperinflation. Unlike Britain, in France inflation had put the old parity hopelessly out of reach. As a consequence, France returned to gold at a parity that undervalued the franc. Scarred by its experience with inflation, France sterilized gold inflows to prevent a rise in prices.
Allied war debts and reparations added to the inherent fragility of an international gold standard programmed for deflation. They required the transfer of resources from Germany to France and England and then from these countries to the United States. To accomplish these transfers, Germany would have had to run a trade surplus toward France and Britain. In turn, France and Britain would have had to run a trade surplus toward the United States. In the protectionist environment of the 1920s, that trade pattern was politically unacceptable. Only capital outflows from the United States made the system work (Yeager 1976, 333; Holtfrerich 1989, 151). (19)
World Deflation
By the end of 1927, it appeared that Europe had successfully returned to the gold standard. However, in 1928, the Federal Reserve initiated a restrictive monetary policy to stop stock market speculation. In 1920 and 1921, a floating exchange rate had insulated Germany from deflationary U.S. monetary policy. In those years, German industrial production rose 46 and 20 percent, respectively. In contrast, in Britain, whose commitment to return to the gold standard at the prewar parity overvalued its exchange rate, industrial production fell 32 percent in 1920. (20) At the end of the decade, a revived international gold standard transmitted U.S. deflation to Germany.
In the 1920s, capital had flowed into Germany. That is, Germany exported not only goods, but also IOUs. When the Federal Reserve System began raising interest rates in 1928, those capital inflows lessened. Germany then could not use funds gained from capital inflows to pay its reparations, but instead had to run a trade surplus to gain the needed funds. The price level in Germany had to fall to make its exports more attractive to the rest of the world. By the last half of 1929, foreign debt issued in New York was less than a third of its 1927 level (Chandler 1958, 456). "Net portfolio lending by the United States declined from more than $1000 million in 1927 to less than $700 million in 1928 and turned negative in 1929" (Eichengreen 1995, 226). (21)
As a result, in 1928 U.S. financial markets began attracting gold from Europe. (22) Foreign central banks had to raise their domestic interest rates to offset gold losses. The Federal Reserve Bulletin (November 1930, 655) talked about "Money rates abroad, which had been kept up largely to protect the reserves of foreign countries against the attraction of speculative and high-money conditions in the United States." George Harrison, governor of the Federal Reserve Bank of New York, informed Secretary of the Treasury Andrew Mellon that "our high money rates... continue to act as a pressure upon all the European bank reserves." (23) At the same time, France, with its undervalued franc, also absorbed gold from the rest of the world. In 1928 and the first half of 1929, France absorbed 3 percent of global gold reserves (Eichengreen 1995, 216).
To reverse their gold outflows, other countries had to run a trade surplus with the United States and France. Because the Fed and the Banque de France sterilized gold inflows, those other countries had to achieve trade surpluses through deflation. That is, to make their goods cheaper on international markets, their price levels had to fall. By creating obstacles to trade, protectionism exacerbated the extent of the required deflation. (24) The gold standard became an engine of worldwide deflation. The most visible signs of the stress of deflation were financial panic and widespread bank failures as depositors withdrew gold and currency from banks.
Both international and domestic considerations compelled Germany to deflate rather than abandon the gold standard. The Banking Act, created in 1924 as part of the Dawes reparations plan, required Germany to back its currency with gold and foreign exchange reserves equal to 40 percent of its currency. A foreign member of the General Council, set up to oversee the Reichsbank, could stop note issue if he believed gold convertibility was threatened (James 1999, 25).
The foreign loans from the Morgan syndicate required Germany to stay on gold. Those loans allowed Germany to finance its reparations payments. Germany also believed that adherence to the gold standard would provide it with a reputation for financial conservatism that would make credible its efforts to renegotiate reparations obligations. Finally, and most important, seared by the memory of hyperinflation, German public opinion supported the gold standard. Germans associated abandonment of the gold standard with inflation (Bresciani-Turroni 1937, 402; Eichengreen 1995, 270; James 1999, 25). Politicians had difficulty supporting a possibly inflationary policy without appearing to favor large industry and agriculture, which as debtors had profited from the earlier inflation (Feldman 1997, 853).
The 1931 German Financial Panic
As noted above, the Reichsbank had to maintain at least a 40 percent gold cover, that is, a gold-reserves-to-note circulation ratio of 40 percent. In April 1929, with the near collapse of reparations negotiations in Paris, reserve outflows threatened the gold cover. In May 1929, the successful resumption of the negotiations reestablished calm and led to the Young Plan, signed in June. In September1930, when elections gave Hitler's party the second largest majority in the Reichstag, gold outflows from the Reichsbank resumed; aid from an international consortium relieved the crisis. In May 1931, the gold cover had risen to a comfortable 60 percent. (25)
Any lasting restoration of investor confidence in the mark's gold parity would require settlement of the reparations issue. (26) Investors worried whether Germany could finance reparations payments in the absence of continued capital inflows. They also worried about the political instability within Germany caused by reparations. Right-wing parties demanded that Germany renounce reparations. The Bruening government had been unable to form a parliamentary majority since July 1930. Chancellor Bruening dismissed the Reichstag and governed without it.
At the beginning of June 1931, the Reichsbank again began to lose gold. (27) This worsening in the German balance of payments ultimately occurred at this time because the deflationary pressure of U.S. monetary policy intensified. The U.S. money stock M2 had declined only 2 percent in 1930. In 1931Q1 and 193 1Q2, it fell at an annualized rate of 6.3 and 6.7 percent, respectively. In 193 1Q3, M2 declined at an annualized rate of 11.3 percent (Friedman and Schwartz 1963). (28)
Bank failures in Austria and Hungary were the immediate source of the financial panic in Germany. The first of these was the failure of the Austrian Credit-Anstalt bank in mid-May 1931, after which Austria suspended gold convertibility and allowed its currency to depreciate. Because foreigners held half of German bank deposits, financial stability required that foreign investors retain confidence in the maintenance by Germany of its gold parity (Eichengreen 1995, 272). Only American leadership could have achieved that result.
On 20 June 1931, President Hoover proposed a one-year moratorium on reparations and Allied debt payments. Financial markets worldwide responded positively (Eichengreen 1995, 277). However, French ill will toward Germany delayed the negotiations until a debt moratorium was too late to help. French reluctance to agree to the Hoover moratorium made investors nervous. That nervousness caused the financial panics in Austria and Hungary to jump the border to Germany. (29)
The appendix, "The Federal Reserve Bank of New York and the Reichsbank during the 1931 Crisis," provides an account of these events recorded in memos by Governor Harrison of the New York Fed. Central banks had cooperated to maintain the gold standard in the twenties. Walter Bagehot, a British economist, had expounded the lender-of-last-resort principle of lending freely at a high interest rate in a financial crisis (Bagehot 1873). These precedents suggested that the New York Fed, the Bank of England, and the Banque de France would lend to the Reichsbank. Had they done so, it is possible that monetary contraction and the fall in the German price level necessary to improve Germany's trade balance could have occurred in an orderly fashion. However, as a condition for a loan, the New York Fed required that the Bundesbank cease lending to commercial banks. The Reichsbank's compliance precipitated the collapse of its banking system, and the New York Fed then failed to come through with a loan.
Between 1926 and 1932, the Reichsbank maintained short-term interest rates at around 6 percent (Figure 3). (30) Figure 4 shows that significant deflation began in 1929 and continued through 1932. Despite this deflation, the Reichsbank kept market interest rates high. Table 1 shows the realized real rate of interest -- the market rate minus actual inflation. This series rose moderately through 1929 and dramatically in the years 1930, 1931, and 1932. (31)
Monetary contraction allowed the Reichsbank to maintain high real rates of interest. Given the stability of monetary velocity (Figure 3), monetary contraction required a decline in nominal output (Figure 5). (32) Real output peaked in 1928 and then fell 16 percent through 1932. Only in 1933 did output begin a modest recovery (Figure 6 and Table 2). (33)
Discrediting Capitalism
Given its adherence to the gold standard, Germany had to prevent capital outflows to avoid deflation and use fiscal authority to persuade international creditors of its credit worthiness. As German recession deepened, the government cut the social programs instituted after the war. The public therefore associated the market discipline of capitalism with government neglect of social needs. (34)
"The Reichsbank thus succeeded in cutting back the social programs started after the [1918] revolution.... The public perceived a dramatic failure of free market capitalism. They fell all the harder for the economic populism of the National Socialists" (Webb 1989, 127). Capitalism in the twentieth century did not appear to be a system that enriched the masses. Instead, it appeared to be a system that allowed the strong to exploit the weak. The depression discredited capitalism.
Harold James (1986) writes:
It was the outbreak of the banking crisis in the summer of 1931 that made the German depression so severe....[T]he collapse of the banks in central Europe had a major social, psychological and political impact. Capitalism appeared to have crashed with the banks, and this helped to discredit existing political systems. (283-84)
The years following the 1923 stabilization had offered the promise of a return to stability. The Young Plan for German reparations, adopted in principle at The Hague in August 1929, promised an end to reparations in 1988. Right-wing German parties rejected reparations and the "war guilt lie" they represented (Nicholls 1968, 137). Nevertheless, in early 1930 these parties, including the Nazi party, were marginal. Their marginal status changed with the spread of the depression. Under the stress of the deflation that began in 1929, Germany could not keep together a political coalition capable of maintaining the democratic institutions of the Weimar Republic. Hitler was the clear beneficiary of the nationalist resentments revived by rising unemployment. (35) The unemployment rate averaged 28.1 percent in 1932 (Table 2). Hitler became chancellor of the government in January 1933. (36)
When Hitler came to power, the Reichsbank began to discount bills to finance his public works and rearmament program. In 1936, Hitler imposed a price freeze to control inflation. He said, "Inflation is a lack of discipline......... I'll see to it that prices remain stable. That's what my storm troopers are for" (Feldman 1997, 855). And again, "The first cause of the stability of the currency is the concentration camp" (James 1999, 35). Schacht, who became Reichsbank president for the second time in March 1933, maintained the mark price of gold by imposing foreign exchange controls and barter arrangements for foreign trade. "Germans who settled foreign debts directly with their creditors were threatened with the death penalty" (Pringle 1998, 71). Germans rejected the arbitrary redistribution of wealth produced by hyperinflation and the unemployment produced by deflation. With the discrediting of capitalism, they turned to monetary arrangements that required the detailed control of individual behavior by the st ate.
3. THE BIRTH OF THE D-MARK
Once capital controls effectively ended the gold standard, the Reichsbank was able to finance Germany's rearmament and war expenditures by printing money. Price controls created suppressed inflation. After the war ended, the Allied occupation forces maintained the price controls, and inflation continued to be suppressed.
The currency reform of 1948 ended price controls and introduced the deutsche mark (DM). The ensuing period of strong economic growth (the Wirtschaftswunder) and the resulting monetary stability contrasted with the hyperinflation and subsequent deflation of the Weimar Republic. That contrast bred the presumption that economic and social stability required monetary stability, and this widespread presumption later created popular support for the "stability" policy of the Bundesbank.
Price Controls and Suppressed Inflation
Despite the devastation of World War II, Germany was in a position to recover economically after the war. Buchheim (1999) writes:
The conditions for resuming production in western Germany were actually very good. Despite the war dead, the influx of refugees and expellees saw a sharp rise in the general population....[M]any of the newcomers had been employed in industrial production occupations and had the appropriate skills....[N]ew investments during the war had far exceeded the plant facilities destroyed. For this reason, West German industrial assets in 1945 were not only greater than before the war, but also more modern. (57-58) (37)
However, in 1947, two years after the end of the war, industrial production in Germany amounted to only 40 percent of its 1936 level. Price controls throttled German economic recovery. In other Western European countries, which also suffered war damage but did not have price controls, output exceeded the prewar level by 1947 (Yeager 1976, 388).
From 1936 through 1944, money (measured by currency in circulation plus total bank deposits) rose somewhat more than sixfold (Table 2). Despite this rise in money, price controls restrained the rise in the official consumer price index to only 14 percent from 1936 through 1944. Germany therefore ended the war with suppressed inflation. The Allies kept Hitler's price freeze in effect during the postwar occupation. Goods traded on the black market or through barter because no one wanted to exchange goods for marks at the artificially low price level. (38)
Germans used nylon stockings, American cigarettes, and Parker pens for currency. For example, in 1945, ten cigarettes could be exchanged for 1,500 grams of bread and two pairs of stockings for 1.5 pounds of butter (Haus der Geschichte). (39) American soldiers could obtain those items from the PX. Germans resented the privileges that this commodity money gave Americans. General Clay, the American military governor, responded to this resentment by strictly enforcing the law against black market transactions (Smyser 1999, 44).
Allied enforcement of price controls paralyzed the German economy. For example, farmers would not bring crops to market. Children died of malnourishment and food riots broke out (Smyser 1999, 31-32). Controls discouraged work effort. With little effort, workers could earn enough marks to buy all the rations allowed them by their ration cards. At the same time, the artificially low wage rates did not permit workers to work long enough to buy the goods that were available at black market prices (Buchheim 1999, 60; Haus der Geschichte).
Paradoxically, the depressing effect of the controls on economic activity seemed to assure their survival. Germans overwhelmingly saw the end of controls as relinquishing the certain for a frightening uncertainty. Most believed that the disappearance of the ration cards and the minimum of sustenance that they assured would push the impoverished over the line into destitution (Bark and Gress 1989, 197).
Currency Reform
By early 1947, U.S. Secretary of State George Marshall understood fully the desperate condition of Europe. He had come to believe that Stalin would not accept a unified Germany except under Russian control. Marshall and Ernest Bevin, the British foreign minister, concluded that the West had to reconstruct Germany without the Soviet Union (Smyser 1989, 55-56). On 5 June 1947, Marshall proposed what later became known as the Marshall Plan. The United States wanted an economically viable Western Europe, which required a prosperous Germany. Currency reform was a vital ingredient of economic reconstruction. Germany needed a universally accepted currency to be able to trade freely both within and across its borders.
The American economic advisers to General Clay prepared a plan for currency reform based on reforms in Russia and Czechoslovakia (Clay 1950, 209). The reform preserved the relatively low level of controlled prices by converting wage rates and pension payments one-for-one from reichsmarks to the new DMs. However, it eliminated the monetary overhang inherited from the Third Reich by limiting the quantity of reichsmarks that could be exchanged for DMs. Under the terms of the reform, which came into effect 20 June 1948, West Germans could turn in 60 reichsmarks on a one-to-one basis. Further exchanges occurred at a ratio of ten to one. The monetary authority converted assets and savings deposits at a sharply reduced rate. (40)
Clay (1950, 210) feared that the reform would favor the German "trend toward socialism" by destroying the financial "savings of the little man" while rewarding the "black market operators who had invested their huge gains in real estate." Therefore, the original plan included provisions for a capital levy to compensate the losers from the ten-to-one write-down of the reichsmark. However, Marshall insisted on limiting the reform to the currency exchange.
The German economic miracle began with the currency reform of June 1948. When the currency reform was announced, Ludwig Erhard, economic director of the joint American-British Bizonal Economic Administration, decreed the end of price controls. The day the price controls ended, goods returned to store shelves. With the end of controls, "euphoria engulfed most Germans at the sight of goods and food items they could only dream about in the past. Bakeries miraculously produced and displayed delicious cakes; vegetables, butter and eggs appeared in abundance" (Bark and Gress 1989, 201).
Industrial production in West Germany rose 25 percent within two months and 50 percent within six months (Buchheim 1993, 72; Marsh 1992, 173). With prices that made crops worth selling, West Germany a gain had enough food (Smyser 1999, 50). From 1948 through 1950, GDP growth in Germany remained above 15 percent per year. In the 1950s, Germany grew at an average annualized rate of 8 percent (Giersch et al. 1992, 2, Figure 1).
Nevertheless, immediately after their introduction, the fate of the Erhard reforms remained in question. The currency reform carried the opprobrium of destroying the financial wealth of ordinary Germans while enhancing the tangible wealth of those holding productive capital. It thus restored the industrialists' economic position, which had created envy in the Weimar Republic and Third Reich. Many Germans wanted a reintroduction of price controls, believing they would make basic goods and food affordable. In November 1948, more than 9 million German workers engaged in a general strike (Merkl 1963, 107).
