V. After WWI – Economic Turmoil of 1920s

1. V. After WWI – Economic Turmoil of 1920s

2. V.1 Economic consequences of Versailles peace

3. 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

4. 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

5. 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

6. 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

7. 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

8. V.2 Hyperinflations of early 1920s

9. 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!

10. V.2.1 The data

20. Summary: selected facts(Source: Cagan – see Literature)

21. 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)

22. V.2.2 Sources and origins

23. 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

24. 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)

25. 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

26. 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

27. 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

28. 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

29. V.2.3 Stabilizations and lessons

30. 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

31. 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

32. 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 10-20%) • In different countries differently, but in all cases the strategy was to return to gold standard

33. 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

34. 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

35. 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

36. V.3 Return to the gold standard

37. 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

38. 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

39. Real growth 1925-1930

40. 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

41. 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).