V. After WWI – Economic
Turmoil of 1920s
V.1 Economic consequences of
Versailles peace
World War I
• Massive military conflict, end of established
system
• Political consequences:
– new political map of Europe
– political weakening of the main European powers
(both winners and losers), strengthening of the
USA
– emergence of Bolshevism in Russia
– “end of the world”
– an attempt to establish a new international order:
14 points of President Wilson
Economic consequences of
WWI
• Immense human and material losses,
dramatic fall of standard of living
• European countries abandoned gold standard
(not the USA) and pre-war international
financial order ceased to exist
– end of the system of fixed exchange rates
– no free flows of gold and capital in general
• Excessive indebtedness of European
countries (again both winners and losers)
• End of social order in its pre-war form
Economic aspects of Versailles
treaty
• Old debts appended by new debts
– war reparation and the discussion on maximum
limit Germany can pay
– compensation payments
– difficult (impossible) timetable to repay
• Alsace-Lorraine back to France, Saarland
internationalized
• Opposition on the side of the winners –
John Maynard Keynes, The Economic
Consequences of the Peace
Implications
• Fragmentation of the global economic
system
– Germany – condemned to economic misery
– Soviet Union – self-imposed isolation
– European economies – increase of
protectionism, end of free trade and free flows
of capital
• Monetary and financial matters
– Britain (and sterling) was not able to play the
role of leading economy, much stronger USA
were not prepared/willing
Perils
• Economic instability
– additional factors: new structure of costs
and increasing price and wage rigidity
• Radicalization of population in Germany
(Bolshevism, Nazism)
• Lack of international coordination of
economic policies
 seeds for Great Depression and WWII
V.2 Hyperinflations of early 1920s
Layman’s evidence
• 1913 - value of all currency in Germany was 6
billion marks
• October 1923 – the same amount was enough
to buy one kilogram of bread
• Months later – the price of same bread was
428 billion mark
• Comparable situation in 4 countries: Austria,
Hungary, Poland and Germany
– Not in Czechoslovakia!
V.2.1 The data
Summary: selected facts
(Source: Cagan – see Literature)
Austria
Hungary
Poland
Germany
1. Start
Oct. 1921 Mar. 1923 Jan. 1923 Aug. 1922
2. End
Aug. 1922 Feb. 1924
3. No. month
Jan. 1924 Nov. 1923
11
10
11
16
4. PT/P0
69.9
44.0
699.0
1.02x1010
5. MT/M0
19.3
17.0
395.0
7.32x109
6. (4)/(5)
3.62
2.59
1.77
1.40
7. Avg.gr.P
47.1
46.0
81.4
322.0
8. Avg.gr. M
% per month
30.9
32.7
72.2
314.0
9. (8)/(7)
1.52
1.41
1.13
1.03
% per month
Comment to summary
• Definition of hyperinflation
– start: the month where inflation > 50%
– end: months before month when inflation dropped
bellow 50% and stayed there for a year
• Clear trends in extraordinary growth of prices
and of amount of nominal money, but
– extreme volatility in particular months
– huge differences in magnitudes across the 4
countries
– numerical characteristics become closer only
when we compare averages (row 9)
V.2.2 Sources and origins
Broad origins
• War damages, post-war turmoil, unrealistic
reparations payments
• Structural problems
– Austria, Hungary: small countries, that inherited
structure of a large empire
– Germany: political and moral decay, unpopular new
democracy (Weimar Republic)
– Poland: extremely stripped of the resources during
the war, peace restored only in 1920
• All countries:
– extreme poverty (need for social payments)
– inefficient state enterprises, providing vital
functions (need for subsidies)
– except Poland, obligation to pay reparation
Budgets: deficits
• All countries: substantial budget deficits,
because of
• Expenditures – see above
• Income
– time lag between the moment of tax being
levied and time when collected: loss of value
due to inflation
– Inefficient collection, in Germany even to
some extent a Government policy, as a protest
against reparation (and later, French
occupation of Ruhr)
Budgets: financing
• Governments
– not able to pursue quick structural changes
– social priorities: to ensure at least basic social
and administrative order and services
– and - maybe - underestimation of inflationary
threat
– consequently, given the reparation, expenditures
given
• Inability to borrow
• The only way – monetization of the debt
Debt monetization
• Weak monetary institutions, no independent central
banks
• Borrowing from monetary institutions, that created new
money
– short-term government obligations (T-bills), purchased by state
monetary institutions
– un-backed by gold or foreign exchange reserves
– huge discounting of new notes: e.g. on Austrian notes, interest
equal 6-9% when inflation was of order of 104, in Hungary even
private notes with low interest were discounted by Central Bank
– excessive demand, need to ration the purchase of state notes
• This created large increase of high-powered money,
total money supply further inflated by money multiplier
Hyperinflations
• In all countries this process reached a
momentum (in different periods), when
inflationary spiral started
• Basic causality: budget deficits  money
growth  inflation
– consistence with quantity theory of money
– role of inflationary expectations
• Other accompanying features
– depreciations of the currencies
– flight from domestic currency, regulations trying to
prevent it, but
• inefficient, black market
• part of money supply held in foreign currencies
Impact on economy and policy
• Monetary economy less and less efficient
• Price signals ceased to be useful
– higher variation of relative prices
• Much larger and faster changes in inflation
• Expectations that the state will finance debt
further on
• Real economy – in the short run - running (a)
relatively “well”, (b) independently on
hyperinflation
– consistency with classical model predictions
V.2.3 Stabilizations and
lessons
Basic steps
Common for all four countries
• Credible commitment of central bank that it
will not monetize debt any more
– radical change in people’s expectations!
• Fiscal reform, reduction of budget deficit
– stabilizing tax system
– reform on the expenditure side (end of subsidies,
laying-off excessive state bureaucracy, etc.)
• Central Banks legally forbidden to lend to
Governments
Specific steps (1)
More country specific steps:
• Loans:
– Austria (League of Nations), Poland only in 1927,
Hungary placed (issued) the loan abroad, secured by
state salt and tobacco monopolies, no loan for
Germany
• Reconsideration of reparations: all except
Poland, crucial for Germany (Dawes plan)
• Currency reform: Poland and Germany in the
moment of stabilization, Hungary slightly later,
Austria substantially later
– but just change of numeraire
Specific steps (2)
• After sheer depreciations, countries
stabilized their ExR and were able to
maintain it, but thanks to
– drastic devaluations
– massive interventions
– large nominal interest (in first months 1020%)
• In different countries differently, but in
all cases the strategy was to return to
gold standard
Other issues (1)
Real economy
• There was a slow-down of output and increase
of unemployment as a consequence of
stabilization, but
– shortly, followed by period of economic growth (till
Great Depression), Poland back to smaller crisis in
1927
– unemployment increase much milder than expected
(in Germany more difficult)
• Still acceptable consistency with classical
model
Other issues (2)
• Increase of money supply even after the
price stabilizations, contradiction to
QTM, but
– money issued after stabilization were state
liabilities, back by gold, foreign loans and –
mainly – by the renewed state ability to
collect taxes
• Consequently – the new money was not
inflationary
• Return from foreign currencies into new
domestic ones
Lessons
• Essential stabilization steps: simultaneous (a) creation of
independent central bank, that stopped unsecured lending
to the state, (b) change of fiscal policies, (c) change in
inflationary expectations, (d) stabilization and defense of
ExR
• Government could borrow only with private sector and
debt was ultimately backed by its ability to collect taxes
efficiently
• The main source of hyperinflation: growth of currency that
was backed by government bills, unsecured by future state
incomes
• This created expectations that further fueled the inflation
spiral, unless being broken by newly, generally trusted
central bank’s policy
• Earlier attempts to stabilize that failed (e.g. Germany):
unless accompanied by fiscal reform, doomed to fail
V.3 Return to the gold standard
Second period of gold standard
• 1925-1931, most countries re-adopted
gold standard
• During 1924 – stabilization of exchange
rates even in countries that suffered
hyperinflations, but, namely between
sterling and dollar
– positive strong correlation between relative
prices (both in UK and USA) and exchange
rate ₤/$
– April 1925: Britain decided to return to gold
standard at pre-war parity
Churchill’s policy mistake
• In 1925, Winston Churchill – UK Chancellor of
the Exchequer
• Under new conditions – sterling overvalued
– after the war, British prices increased faster than
those of trading partners, return to pre-war parity =
real appreciation
– consequence: loss of international competitiveness
• Keynes: The Economic Consequences of Mr.
Churchill
Real growth 1925-1930
Weakness of 2nd gold standard
• Overvalued sterling
• Adjustment mechanism worked
badly
• Rigid prices and wages
• Much more complex political and
economic environment
• More than one financial center
Literature to Ch. V
After WWI economic order:
• Keynes, John M. The Economic Consequences of the Peace.
London, Macmillan, 1920.
Hyperinflations:
• Textbooks by Blanchard (pp.447-452) or Mankiw (pp.180-186).
• Sargent, Thomas J., The End of Four Big Inflations, in: Hall, Robert,
ed., Inflation. Chicago: University Press, 1983.
• Dornbush, Rudiger, Fisher, Stanley, Stopping Hyperinflations: Past
and Present, Weltwirtschaftliches Archiv 122 (1986), pp.1-47.
• Cagan, Phillip, The Monetary Dynamics of Hyperinflation, in Milton
Friedman (ed.), Studies in the Quantity Theory of Money, Chicago
(1956, pp. 23 – 117.
Return to Gold Standard:
• Textbook by Blanchard (pp.405-6).
• Keynes, John M., The Economic Consequences of Mr. Churchill.
1925 (in: Collected Writings).