European Economic History II (1914 -
up to now)
Week 2: War, Debt and Inflation
Required readings:
● Eichengreen (1992), ch.5
● Sargent (1981)
Economic consequences of WWI
New division of political power
- New states emerged
- introduction of universal suffrage (everyone has a right to vote)
- changed attitudes towards immigration and radical ideologies (much more restrictive)
New techniques for government intervention and economic planning
- the mobilization for the war fostered development of a new planning techniques: in
Germany Walther Rathenau designed the first planned economy (these techniques
were further developed by Nazis - Input-Output tables)
- government became much more active in the economy than before
Huge war debts due to debt financing during the war
- European Allies could win only with US-support, which caused huge debts
- Allies wanted to recover it from defeated states
- Reparations claims against Germany, Austria, Hungary (it was not decided
until 1920 since it was not settled in Paris peace conference in 1918)
- International and domestic conflict about reparations caused inflation and
hyperinflation in these countries
- Amount of reparations Germany had to pay changed over time due to
its inability to pay:
- Treaty of Versaille 1919 and London Schedule of Payment
1921: 132 billions of German gold marks
- Dawes Plan 1924: modified the schedule of payments,
international loans to Germany
- Young Plan 1929: 112 billions of German gold marks
- Lausanne Conference 1932: payments were canceled,
Germany paid around 20 billions of German gold marks
- Three types of bond reparation payments:
- A: covering direct costs of the war
- B: covering debts of UK and France to the US
- C: not directly fixed, it was more of a propaganda in order for people to think
the amount that defeated countries would pay is higher
,The Transfer Problem: Keynes-Ohlin Problem
Why is it not possible for Germany to transfer (export) the amount of resources required by
the reparations?
Keynes:
- burden might be too large (reducing domestic absorption)
- terms of trade: prices of transferred goods decrease relative to import prices, which
undermines value of exports.
However Ohlin argues that this might not be the case since due to transfer, foreigners are
becoming richer and their demand for German goods is increasing and in that way it restores
prices
- This depends on bias in endowments to bias in preferences and transport costs
Government can do following to reduce the debt:
- raise taxes
- increases trade surplus as it lowers aggregate demand and imports foreign
demand
- it allows government to serve foreign debt without affecting exchange rate
- PROBLEM: political resistance at home
- borrow more money
- paying debt with new debt
- budget deficit might stimulate domestic economy
- at some point it results in increase in interest rates, decline in investment,
domestic activity and import demand as well as decline in attraction of foreign
capital flow
- not feasible in long run
- print money
- this causes inflation, which further affects exchange rate
- printing money is the last option
When the debt is in foreign currency, it is necessary to have a current account surplus
(having more exports than imports), which can lead to appreciation of domestic currency.
Hyperinflation
Inflation: a sustained increase in the average price level of goods and services in an
economy over some period. This is equivalent to a loss of money’s purchasing power.
Hyperinflation: an extreme form of inflation. According to Cagan (1956), monthly inflation of
50% marks transition from inflation to hyperinflation
Story of Germany, Austria, Hungary and Poland
- massive budget deficits and large increase in money supply
- sudden end of hyperinflation caused by change in monetary and fiscal regime
,Sargent (1982) - common features of hyperinflation in different countries:
1. Enormous budget deficits on current account
2. Deliberate and drastic fiscal and monetary measures taken to end the hyperinflation
3. The immediacy with which the price level and foreign exchanges suddenly stabilized
4. The rapid rise in the "high-powered" money supply in the months and years after the
rapid inflation had ended
Germany
1920: political resistance against planned extent of reparations
- effect: reduction in tax income, central bank starts to print money causing inflation
and collapse of exchange rate
1923: due to Germany’s inability to repay, France occupied Ruhr
- German government and trade unions call a general strike, government pays salaries
with printed money and inflation is getting out of control
1924: Dawes plan - new deal that lowered immediate and total burden on reparations and
aided by international loans
- Germany entering Gold Standard again
- End of hyperinflation
Austria
- loss of territory, trade barriers that created cut off from previous food sources, high
unemployment, reparations - all this results in large government deficits and increase
in volume of the money
- people choose to hold less of their wealth in form of domestic currency -
depreciation of Austrian crown
- The depreciation of the Austrian crown was suddenly stopped by the
intervention of the Council of the League of Nations and the resulting binding
commitment of the government of Austria to reorder Austrian fiscal and
monetary strategies dramatically.
- New policies / protocols that resulted in stabilization of currency:
- declaration signed by Great Britain, France, Italy, Czechoslovakia, and Austria
that reaffirmed the political independence and sovereignty of Austria
- international loans
- Austrian plan for reconstruction of fiscal and monetary affairs
Hungary
- loss of territory and reparations owed to winners: substantial budget deficit financed
by borrowing from State Note Institute (which also made loans to private agents)
- currency depreciated and domestic prices rose rapidly
- financial reconstruction was accompanied with intervention of League of Nations:
- political independence and territorial integrity
- reconstruction loans
, Poland
- Large government deficits financed by borrowing from Polish State Loan Bank
- Sudden stop of hyperinflation in January 1924
- Unlike in the case of Germany, Austria and Hungary, it was achieved without
foreign loans and intervention, but due to a dramatic move toward a balanced
government budget and the establishment of an independent central bank
that was prohibited from making additional unsecured loans to the
government.
- New currency: gold zloty
Causes of hyperinflation:
Eichengreen (1995)
Theory 1: Balance of Payment Theory (inflation caused abroad)
- CURRENT ACCOUNT DEFICIT AND DEPRECIATION OF DOMESTIC CURRENCY:
more imports, less exports plus reparations, causing deterioration of terms of trade
(import prices rising faster then export prices) and German Mark devaluation (since
you do not export you do not get foreign currency, and for import you pay with
domestic currency so there is surplus of your currency compared to foreign currency)
- this results in imported inflation
- increased cost of production leads to declining tax revenue, budget deficit and
incentive to print money - causing hyperinflation
- according to this theory, the growth of money supply was an effect, not the cause of
inflation
Theory 2: Quantity Theory (inflation caused at home)
- money X velocity = price X real GDP
- V is assumed to be stable, thus increase in M implies increase in nominal GDP (price
X real GDP)
- However, money is neutral and does not affect economic activity (GDP), so it
triggers proportional increase in price.
- Change in money supply is the root for (hyper)inflation
- if velocity (rate of money circulation) increases with inflation (when we expect that
money is worth less in the future, we will spend it now), expectations of inflation will
cause hyperinflation (Cagan, 1956)
Inflation leads to rising commodity prices and fall in the exchange rate
Theory 3: modern view - expectations
In order to end hyperinflation, change the expectations of agents!
- If agents are rational: they understand the mechanism that drives price levels and
change in that mechanism can have immediate effect on expectations and inflation.
Change in policy does not need to be costly
- If agents are adaptive (short- sighted) - high persistence in inflation, change in fiscal
and monetary policy will be accompanied by only slow reduction in inflation, hence
costly
up to now)
Week 2: War, Debt and Inflation
Required readings:
● Eichengreen (1992), ch.5
● Sargent (1981)
Economic consequences of WWI
New division of political power
- New states emerged
- introduction of universal suffrage (everyone has a right to vote)
- changed attitudes towards immigration and radical ideologies (much more restrictive)
New techniques for government intervention and economic planning
- the mobilization for the war fostered development of a new planning techniques: in
Germany Walther Rathenau designed the first planned economy (these techniques
were further developed by Nazis - Input-Output tables)
- government became much more active in the economy than before
Huge war debts due to debt financing during the war
- European Allies could win only with US-support, which caused huge debts
- Allies wanted to recover it from defeated states
- Reparations claims against Germany, Austria, Hungary (it was not decided
until 1920 since it was not settled in Paris peace conference in 1918)
- International and domestic conflict about reparations caused inflation and
hyperinflation in these countries
- Amount of reparations Germany had to pay changed over time due to
its inability to pay:
- Treaty of Versaille 1919 and London Schedule of Payment
1921: 132 billions of German gold marks
- Dawes Plan 1924: modified the schedule of payments,
international loans to Germany
- Young Plan 1929: 112 billions of German gold marks
- Lausanne Conference 1932: payments were canceled,
Germany paid around 20 billions of German gold marks
- Three types of bond reparation payments:
- A: covering direct costs of the war
- B: covering debts of UK and France to the US
- C: not directly fixed, it was more of a propaganda in order for people to think
the amount that defeated countries would pay is higher
,The Transfer Problem: Keynes-Ohlin Problem
Why is it not possible for Germany to transfer (export) the amount of resources required by
the reparations?
Keynes:
- burden might be too large (reducing domestic absorption)
- terms of trade: prices of transferred goods decrease relative to import prices, which
undermines value of exports.
However Ohlin argues that this might not be the case since due to transfer, foreigners are
becoming richer and their demand for German goods is increasing and in that way it restores
prices
- This depends on bias in endowments to bias in preferences and transport costs
Government can do following to reduce the debt:
- raise taxes
- increases trade surplus as it lowers aggregate demand and imports foreign
demand
- it allows government to serve foreign debt without affecting exchange rate
- PROBLEM: political resistance at home
- borrow more money
- paying debt with new debt
- budget deficit might stimulate domestic economy
- at some point it results in increase in interest rates, decline in investment,
domestic activity and import demand as well as decline in attraction of foreign
capital flow
- not feasible in long run
- print money
- this causes inflation, which further affects exchange rate
- printing money is the last option
When the debt is in foreign currency, it is necessary to have a current account surplus
(having more exports than imports), which can lead to appreciation of domestic currency.
Hyperinflation
Inflation: a sustained increase in the average price level of goods and services in an
economy over some period. This is equivalent to a loss of money’s purchasing power.
Hyperinflation: an extreme form of inflation. According to Cagan (1956), monthly inflation of
50% marks transition from inflation to hyperinflation
Story of Germany, Austria, Hungary and Poland
- massive budget deficits and large increase in money supply
- sudden end of hyperinflation caused by change in monetary and fiscal regime
,Sargent (1982) - common features of hyperinflation in different countries:
1. Enormous budget deficits on current account
2. Deliberate and drastic fiscal and monetary measures taken to end the hyperinflation
3. The immediacy with which the price level and foreign exchanges suddenly stabilized
4. The rapid rise in the "high-powered" money supply in the months and years after the
rapid inflation had ended
Germany
1920: political resistance against planned extent of reparations
- effect: reduction in tax income, central bank starts to print money causing inflation
and collapse of exchange rate
1923: due to Germany’s inability to repay, France occupied Ruhr
- German government and trade unions call a general strike, government pays salaries
with printed money and inflation is getting out of control
1924: Dawes plan - new deal that lowered immediate and total burden on reparations and
aided by international loans
- Germany entering Gold Standard again
- End of hyperinflation
Austria
- loss of territory, trade barriers that created cut off from previous food sources, high
unemployment, reparations - all this results in large government deficits and increase
in volume of the money
- people choose to hold less of their wealth in form of domestic currency -
depreciation of Austrian crown
- The depreciation of the Austrian crown was suddenly stopped by the
intervention of the Council of the League of Nations and the resulting binding
commitment of the government of Austria to reorder Austrian fiscal and
monetary strategies dramatically.
- New policies / protocols that resulted in stabilization of currency:
- declaration signed by Great Britain, France, Italy, Czechoslovakia, and Austria
that reaffirmed the political independence and sovereignty of Austria
- international loans
- Austrian plan for reconstruction of fiscal and monetary affairs
Hungary
- loss of territory and reparations owed to winners: substantial budget deficit financed
by borrowing from State Note Institute (which also made loans to private agents)
- currency depreciated and domestic prices rose rapidly
- financial reconstruction was accompanied with intervention of League of Nations:
- political independence and territorial integrity
- reconstruction loans
, Poland
- Large government deficits financed by borrowing from Polish State Loan Bank
- Sudden stop of hyperinflation in January 1924
- Unlike in the case of Germany, Austria and Hungary, it was achieved without
foreign loans and intervention, but due to a dramatic move toward a balanced
government budget and the establishment of an independent central bank
that was prohibited from making additional unsecured loans to the
government.
- New currency: gold zloty
Causes of hyperinflation:
Eichengreen (1995)
Theory 1: Balance of Payment Theory (inflation caused abroad)
- CURRENT ACCOUNT DEFICIT AND DEPRECIATION OF DOMESTIC CURRENCY:
more imports, less exports plus reparations, causing deterioration of terms of trade
(import prices rising faster then export prices) and German Mark devaluation (since
you do not export you do not get foreign currency, and for import you pay with
domestic currency so there is surplus of your currency compared to foreign currency)
- this results in imported inflation
- increased cost of production leads to declining tax revenue, budget deficit and
incentive to print money - causing hyperinflation
- according to this theory, the growth of money supply was an effect, not the cause of
inflation
Theory 2: Quantity Theory (inflation caused at home)
- money X velocity = price X real GDP
- V is assumed to be stable, thus increase in M implies increase in nominal GDP (price
X real GDP)
- However, money is neutral and does not affect economic activity (GDP), so it
triggers proportional increase in price.
- Change in money supply is the root for (hyper)inflation
- if velocity (rate of money circulation) increases with inflation (when we expect that
money is worth less in the future, we will spend it now), expectations of inflation will
cause hyperinflation (Cagan, 1956)
Inflation leads to rising commodity prices and fall in the exchange rate
Theory 3: modern view - expectations
In order to end hyperinflation, change the expectations of agents!
- If agents are rational: they understand the mechanism that drives price levels and
change in that mechanism can have immediate effect on expectations and inflation.
Change in policy does not need to be costly
- If agents are adaptive (short- sighted) - high persistence in inflation, change in fiscal
and monetary policy will be accompanied by only slow reduction in inflation, hence
costly
