Thread by @abhishec_s

Case Study: German Hyperinflation (1918 -1924)

Source: Big Debt Crisis, Dalio

(thread)

Germany was on gold standard at the beginning of the war. All paper currency was convertible to gold at a fixed rate. By 1914 the central bank did not have enough gold to back the stock of money in circulation.

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As the war broke out German citizens rushed to exchange their money for bullion leading to a run on the banking system. To ensure liquidity and avoid major contraction of money, Germany suspended conversion of currency to Gold in July 1914.

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The central bank was allowed to buy short term T-bills as collateral to print more money. Notes in circulation increased by 30%. Currency started to lose one of its two important functions – store of value (the other being a medium of exchange).

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Printing money helps avoid economic contraction and liquidity crisis, which could be detrimental to war efforts. Most countries fighting in WWI ended up suspending the gold standard at one point or another.

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Government spending increased 2.5X between 1914 & 1917. Germany was locked out of international debt markets the war had to be financed with local debt. Government debt increased from insignificant levels to 130% of GDP by 1918. Most of this was denoted in local currency.

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Up until 1916 all war bond issuances were oversubscribed. But later the interest waned as wartime inflation led to real interest turning negative. The inflation (30%) was driven by wartime disruptions, capacity constraints and currency weakness.

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As Germans became increasingly unwilling to purchase government debt, the central bank was forced to monetize the deficit with more money printing.

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Germany started to borrow in foreign currencies (what it could) but inflation at this point was not very different from other countries.

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Conditions for inflationary depressions usually are:

1.Not having a reserve currency
2.Low foreign exchange reserves
3.Large foreign debt
4.Large/Increasing budget/current account deficit
5.Negative real interest rates

By end of war Germany met all these conditions.

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When Germany surrendered people and firms rushed to convert their wealth to foreign currencies and over the next month Mark lost 30% and Equity market lost 50% (in real terms).

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The treaty of Versailles led to Germany losing 12% of its territory, 10% of its population, 43% of its pig iron capacity, 38% of its steel making capacity. The reparation bill was to be determined by a committee later.

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Citizens started fearing extortionately high taxes and confiscation of private wealth. Getting out the currency and country made sense. Inflation was running at 190%.

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At this point money printing was not a source of currency weakness but currency weakness was leading to money printing - a key characteristic of inflationary depression. The currency weakness lead to higher exports, lower unemployment and recovery in equity markets.

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In May 1921 the allies determined the reparation bill as 330% of German GDP. The debt service burden was 10% GDP and 80% of export earnings. The Mark declined 75% by the end of the year.

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The Treaty of Versailles essentially seized all of Germany’s prewar foreign holdings and cancelled all debt owed to Germans. The developed economies themselves were burdened by war debts (owed to US) and were also in midst of severe recession.

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Rising inflation led to surge in retail purchases. This was not a sign of economic activity but rather flight of income and savings into real goods before inflation could eat away the purchasing power of money.

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Foreigners started buying German goods are Mark was extremely cheap. Shelves in shops were bare. Many shops were closed from 1 to 4 in afternoons and most refused to sell more than one article of the same kind. There was widespread starvation.

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Same forces led to massive increase in durable goods purchases. Auto sales climbed to all time highs. Cotton firms refused to take more orders. Most industries were operating at full capacity. Stocks nearly tripled in value in real terms.

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Berlin exchange was so overloaded with orders that it was forced to shut down 3 times in a week. By November markets opened for only one day a week.

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A news article: Today there is no one from lift boy, typist and small landlord to the wealthy lady in high society who does not speculate in industrial securities and who does not study the list of official quotations as if it were a most precious letter.

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Reparation negotiation led to huge surge in currency volatility.

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In July 22, the expectations of reparation settlement collapsed. Foreign capital a huge source of speculation rushed to exit. By July banks were forced to go on a 3-day workweek and depositors were not able to withdraw their cash.

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Currency depreciation and money printing sent inflation skyrocketing. Part of this was due to the scale of the liquidity injection that was needed to offset the pullback in foreign capital, but part of it was also due to changing inflationary psychology.

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By November 1923, the inflation was 36 followed by 9 zeroes %. Total money in circulation in 1913 would just get you about a kilo of rye bread in 1923.

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Eventually Allies relented reducing the debt service burden to 1% of GDP, a new currency was introduced backed by land and gold with limit on money printing.

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