Mythologies: Money and Hyperinflation
In an earlier post, Marc Lee mentioned in passing the German hyperinflation episode of the 1920s. Itâ€™s remarkable that this event still holds such sway over the popular imagination despite other more recent instances of hyperinflation. Certainly, the imagery is powerful: German citizens pushing wheelbarrows full of worthless paper money around for everyday purchases, banknotes used as wallpaper, or dramatic charts showing a hyperbolic spike in the price of gold measured in German marks.
The policy conclusion is equally dramatic: under no circumstances must central banks countenance the idea of â€œprinting moneyâ€ to support government spending. Mankiwâ€™s textbook is illustrative of the common interpretation of this event: â€œWhen the quantity of money started growing quickly, the price level followed, and the mark depreciated relative to the (US) dollar (and gold).â€ Translation: the quantity theory of money holds: MV = PY where V and Y are assumed constant such that any chance in M (money) drives P (prices).
So how to reconcile what we know happened in Germany (money printing, hyperinflation) with MMT views? After all, MMT theorists tend to downplay worries about â€œmoney printingâ€ (a misnomer in the modern world but weâ€™ll let it pass for now). In fact, I wrote a blog post around the time of the first round of quantitative easing where I suggested that resulting concerns about inflation were misplaced and based on a faulty understanding of monetary policy and inflation.
A little more history helps reconcile the MMT view to the standard historical account. Before exploring that alternative story, an acknowledgement: the information used in this post is from a very smart federal bureaucrat who for reasons related to his position, would prefer to remain anonymous. This bureaucrat drew much of his insight from a fascinating historical piece by the St. Louis Federal Reserve, a bastion of monetarist thought and no obvious friend of MMT.
The first thing to understand is that Germany was of course still recovering from World War I. Like most of the countries participating in the war, it had lost countless young men in the bloodshed and seen much of its economy oriented towards war production. Transitioning into â€œnormalcyâ€ was no easy feat for Germany or any of the other European countries involved in the war.
Second, and perhaps more importantly, Germany was operating under the strictures of the Versailles treaty which imposed two types of liabilities on Germany, neither of which were denominated in the newly created German Mark. The first liability required Germany to make reparations in the form of gold bullion which it did not have because its reserves had been severely depleted during the war.
The second liability made it difficult for Germany to acquire these gold reserves through exports â€“ the Versailles Treaty required Germany to make reparation by exporting raw (and some processed) materials; it also ceded large tracts of lands rich in coal resources and industrial capacity to the victors â€“ talk about supply shocks! In the case of coal for example, the combination of lost territory plus reparation exports meant that Germany had to purchase coal on the international market to provide for its own citizens.
The upshot of all this is that Germany was left with two choices to meet its Versailles obligations, both of which amounted to roughly the same thing: it could (a) buy gold in international markets with the newly created German Mark (so-called â€œpaper markâ€) or (b) it could buy production from domestic industries (still using the paper mark) and export the resulting materials as reparations. Since under option (b) the raw material/production exports did not create an inflow of gold into Germany, the private sector was forced to pay for its imports by purchasing gold on international using paper marks. In both case, the German government had to run deficits.
The resulting inflation is perfectly consistent with standard MMT explanations: deficit spending in the context of a massive supply shock (lost human capacity, lost territory, reparation exports) combined with reparation payments priced in gold the country did not have. The gold debt is, however, key to understanding the hyperinflation â€“ with every bout of currency depreciation (relative to gold), Germany had to increase its deficit spending to stay current with its reparation obligations. If, for example, in Period 1, Germany met its reparation requirements by running a deficit equal to 100, and the Mark subsequently depreciated by 50%, then it would have to run a deficit equivalent to 200 to accomplish the same thing in Period 2.
Now run the counterfactual and imagine that the debt was instead denominated in a fixed amount of German marks per year (as opposed to a fixed amount of gold). Suppose further that same deficit of 100 was required to meet Germanyâ€™s reparation obligations in Period 1 and that this resulted in some degree of inflation that led to the same 50% devaluation in the value of the German Mark. In Period 2, Germany would not have to deficit spend one Mark more to meet its obligations because, we will recall, the liability is a fixed nominal amount (and therefore, its deficit spending for reparations purpose relative to nominal GDP would decrease simply as a result of inflation!!). So no spiral, no hyperinflation, no crisis.
Could hyperinflation have been avoided given the Versailles constraints? Perhaps â€“ Germany could have increased taxes to offset additional money creation resulting from spending for War reparations. Indeed, if reparations under Versailles had been somewhat reasonable, raising taxes to avoid inflation may have been politically feasible. However, given the size of war reparations demanded by Versailles relative to Germany’s (shrunken) economy, the taxation option would have constituted a massive transfer of wealth from German citizens to foreigners. Therefore, the option of raising taxes would have amounted to political suicide. Not only were opposition groups in Germany armed and dangerous, but entire sections of the country had only recently been threatening secession, including notably the Bavarian Soviet Republic. The British ambassador at the time is quoted (Source: A. Fergusson, When money dies: the nightmare of the Weimar collapse) as saying for example that: â€œIt is altogether impossible to conceive that twice the new rate of taxation could be imposed without producing a revolution.” One might also quip that the German government of the time might have heeded Marx advice: “there is only one way to kill capitalism – by taxes, taxes and more taxes!”
A couple of footnotes to this recounting:
1. Germanyâ€™s central bank at the time, the Reichsbank, â€œmonetizedâ€ government debt not so much by buying debt directly from government but by buying it from the public to satisfy the publicâ€™s growing need/desire for paper currency. This rising demand was of course due to rising prices â€“ with each uptick in prices, the incentive to unload government debt would increase. Much like today, the central bank passively responded to the resulting currency demand. Just like today, banks had to use excess money (from deficit spending) to either buy government debt (so no shortage of demand) or have it sit idle as excess reserves at the central bank. In other words, there was no shortage of demand for government debt, the central bank â€œmonetizedâ€ debt by buying it from the public, and rising prices drove the demand for paper currency rather than the other way around. The mainstream causal story is backwards.
2. The only unconventional step that the Reichsbank seems to have taken during the Weimar hyperinflation years was when it started buying commercial paper from private businesses. This was done under pressure from German private corporations since it allowed these businesses to be paid right away when they sold merchandises in Mark instead of creating a receivable on the asset side of their balance sheet and waiting to be paid by their customers (due to hyperinflation, this waiting time would have translated into a loss). This phenomenon of course contributed to the inflation problem as it amounted to transforming private debt into public debt, which encourages even more private debt creation, on top of on-going public debt creation.
3. The dominant narrative about Germanyâ€™s hyperinflation period (see Mankiw above) is entirely at odds with the way most German economists viewed this episode at the time. In fact, economists of the German historical school persuasion â€“ deeply influential, incidentally, in the 19th century both in Germany and the United States â€“ tied the hyperinflation to the reparation payments as discussed here. That these arguments have been lost to the sands of time speaks to the mythological nature of the mainstream narrative.
4. Mainstream economists typically struggle to explain why the German people suddenly gained confidence in the Rentenmark (which replaced the Mark) in 1924. Some call it â€œthe Miracle of the Rentenmarkâ€. Consistent with the MMT argument that taxes drive moneyâ€™s value, a less theological explanation presents itself: although the new Rentenmark was not legal tender, it had one very important feature: â€œRentenmark are receivable in all payments to the German Government, but are not legal tender, a quality retained by the old papermark.â€ See p. 111 here.
5. There is no small irony in the fact that today, Germany appears bent on imposing â€œreparationâ€ on Greece by compelling that nation to sell real assets (property, equipment, companies) to settle its financial obligations with the Germany state (remember, Greece canâ€™t devalue its currency).