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1

Hyperinflations

The experience of the 1920s reconsidered

Gustavo H. B. Franco Department of Pontifícia Universidade Católica Rio de Janeiro

Rio de Janeiro, 1989

2 Acknowledgements

This is a revised version of my Ph. D Dissertation originally presented to the Department of Economics in Harvard in 1986. Its main purpose was to join my in and the ambition to extend and develop some of the new ideas and insights produced in connection with the recent experience with high and stabilization policies in Latin America. Before and after my stay in Cambridge I worked in the Economics Department at the Catholic University in Rio de Janeiro (PUC-RJ) thus with a group of that played a major role to the development and application of these new ideas. The constant interchange of ideas and assessments of the current experience was an invaluable source of insights and suggestions. I own special thanks to the group as a whole and very specially the members of my thesis committee at Harvard - Jeffrey Sachs, Barry Eichengreen and Lance Taylor - for their constant encouragement towards a sensitive and rigorous use of economic analysis in understanding history, which I took as a lesson of a permanent character. I should also thank Stephen Marglin, who was very helpful through the steps preceding the writing of this dissertation and Edward Amadeo for help framing this project and devising its relevance. Early presentations at various seminars at Harvard help maturing ideas, I owe special thanks to Susan Vitka and Stephen Haggard for that. I am deeply indebted to my friend Laurent Jacob for sending me otherwise unavailable materials from Europe and Kris Glushowski for sharing with me a vivid picture of Poland in the 1920s. Numerous other seminar presentations in Cambridge and in Brazil, where have become a subject of day-to-day conversation, have improved this work in many respects. Earlier versions of some chapters - 4, 7 and 10 - circulated as working papers and were published in academic journals in Brazil (Pesquisa e Planejamento Econômico and Revista Brasileira de Economia) and abroad (The Economic Journal and Rivista di Storia Economica). I should also thank the Center for European Studies for the fellowship I held in the 3 summer of 1985 that allowed me the opportunity to do research in Europe and the Center for International Affairs for the fellowship I held during the academic year 1985-1986. My deep gratitude is also due to the CNPq - Conselho Nacional de Desenvolvimento Científico e Tecnológico - for financial support during my stay in Harvard. My very greatest debt is with those that bore the most sacrifices along the way, namely my family. My parents' support in exchange for a painful separation from their granddaughter was an extraordinary deal. My wife Vera not only withstood the tensions involved in such a project but also did an extraordinary job helping me with the computer work. This added a whole new dimension to this work, for it turned it into a family enterprise; my dedicating this work to my family is but a minor tribute to their love and support. 4 Contents

1. General introduction and outline

2. Origins and factors

3. Adjustment issues

4. Inflationary finance

5. and adjustment

6. Dollarization

7. Fiscal “reforms”

8. The League schemes

9. Poland: the battle of the zloty

10. The rentenmark “miracle”

11. Epilogue 5 Table of Contents

Acknowledgements ii Contents Table of contents iv Index of tables and charts vi

Chapter 1. General introduction and outline 1.1) Issues and views on the hyperinflations 1 1.1.1) "Schools of thought" 2 1.1.2) Stabilizations 6 1.2) Plan of the work 10 1.3) Chronologies 15 1.3.1) Austria 15 1.3.2) Hungary 17 1.3.3) Poland 18 1.3.4) Germany 19

Part 1: The "fundamentals" of inflation

Chapter 2. Origins and factors for hyperinflations 2.1) Introduction 21 2.2) Stabilizations in the 1920s: an international perspective 22 2.3) Adjustment and borrowing in the 1920s 35 2.4) Contraponto : stabilization after World War II 44 2.5) Summary and conclusions 50

Chapter 3. Adjustment issues in countries 3.1) Introduction 52 3.2) Adjustment problems in the Successor States 53 3.2.1) The new frontiers 59 3.2.2) Czechoslovakia 59 3.2.3) Austria 61 3.2.4) Hungary 63 3.2.5) Poland 65 3.3) Germany: the burden of reparations 68 3.4) and adjustment 77 3.5) Conclusions 88

Chapter 4. Theory and practice of inflationary finance 4.1) Introduction 90 4.2) Monetary models of high inflation 91 4.3) Monetary dynamics of hyperinflations 94 4.4) Endogenous ? 101 4.5) Summary and conclusions 108 Appendix: estimates of money demand and "optimal" inflations 109

Chapter 5. Inflation and adjustment 5.1) Introduction 115 5.2) Inflation in an open economy 117 5.2.1) External balance 117 5.2.2) The dynamic of inflation 119 5.2.3) Equilibrium 123 5.3) External shocks and the generation of high inflation 128 5.3.1) The vicious circle 128 5.3.2) Monetary accommodation 131 5.4) A look at the evidence 135

6 Part 2: The making of stabilizations

Chapter 6. Indexation, dollarization and stabilization 6.1) Introduction 142 6.2) The adoption of indexation 143 6.2.1) Austria 144 6.2.2) Hungary 148 6.2.3) Poland 150 6.2.4) Germany 152 6.3) Dollarization 155 6.4) The making of stabilizations: an outline 159 6.5) Summary and conclusions 168

Chapter 7. Fiscal "reforms" and stabilizations 7.1) Introduction 170 7.2) The League Schemes: Austria and Hungary 171 7.3) Poland 179 7.4) Germany 184 7.5) The meaning of "reforms" 188 7.6) Summary and conclusions 192

Chapter 8. The stabilization in Austria and Hungary: the League schemes 8.1) Introduction 194 8.2) The development of international action: Austria 195 8.3) Following the precedent: Hungary 208 8.4) Summary and conclusions 218

Chapter 9. The stabilization in Poland: the battle of the zloty 9.1) Introduction 220 9.2) Stabilization, investment and the loan issue 222 9.3) Grabski's stabilization plan 228 9.4) The collapse of 1925 234 9.5) Summary and conclusions 238

Chapter 10. The rentenmark “miracle” and the German stabilization 10.1) Introduction 241 10.2) The "stable valued monies" 243 10.3) Indexed monies and inflation explosion 248 10.4) The rentenmark mechanism 253 10.5) Alternative views 260 10.6) The "fundamentals" of the stabilization 265 10.7) Summary and conclusions 273

Epilogue 274 References 277

7

Chapter 1

General introduction and outline 8 1.1) Issues and Views on the Hyperinflations

Hyperinflations are very rare phenomena; less than ten cases have ever been registered in which the 50% monthly inflation threshold has been crossed1, and, at least before the 1980s, only in a few episodes inflation even approached comparable levels. In most cases its occurrence was related to very exceptional circumstances - wars, revolutions and major dislocations - thus conveying the impression that hyperinflations are highly unusual pathologies to be found only in such conditions. Yet, they have attracted an enormous amount of attention; like a rare variety of a common disease, they command great scientific interest. The "extreme case" makes more transparent the ultimate nature of the phenomenon, and thus furnishes some useful keys for day-to-day medicine. The interest on hyperinflations would be reinforced during the mid 1970s, with the worldwide surge of inflation, and especially in the 1980s when one sees concrete indications of the rare disease becoming epidemic. The experience of inflation in LDCs, and especially in Latin America, has come very close to the hyperinflation norm - the 50% monthly rate; in at least one country, Bolivia, the threshold has actually been crossed and at the moment of writing (1989) inflations in Argentina and Peru are just about to do so. More importantly, however, the many similarities between the recent experience and the "classic" cases has led observers, on one hand, to recast the idea that hyperinflations are creatures of times of revolutions, wars and the like, and on the other, to reconsider the very concept of hyperinflation. Indeed, "hyperinflation" is just another word in the jargon to designate "high inflation" and, as recently observed by Cagan himself, it should be nothing more than "an extremely rapid rise in the general level of of and services" and that "there is no well-defined threshold" to characterize it2. The impression that there is little qualitative difference between the recent Latin American cases and the "classic" ones, has turned the latter into an invaluable source of lessons and recipes. From the academic point of view this renewed interest in the "classic" experiences would result very fruitful since an enormous amount of research on inflation and stabilization policies done from the mid-1970s on has produced many new insights, new models and ideas on the nature of high inflations and on stabilization policies; "the

1 Five of which, during the 1920s, three after the World War II and a more recent one in Bolivia. 2 J. Eatwell et al. (eds) (1987) vol. 2, p. 704. 9 only boon from economic hardship is this outburst of thought"3, as put by a leading contributor in this field. These developments opened many new possibilities as regards a revision of the hyperinflation experiences in light of powerful new analytic instruments and a clearer understanding of the nature of the inflationary phenomenon.

1.1.1) "Schools of thought" The visions on the hyperinflations went through several phases, the first of which was one of controversy. During the 1920s until the late 1930s there was a lively debate on the origins of the hyperinflations confronting what has been called the orthodox, or the "English", view - holding that inflation was generated by unbalanced budgets and excessive - and the interpretation, or the "German" view, of the hyperinflations attributing the phenomenon mostly to the unbearable external imbalance created by the payment of war reparations4. This controversy was actually much more than simply an academic dispute: it lied in the very core of the intricate diplomacy of reparations. For this reason the balance of payments view has not enjoyed much popularity in the English-speaking world; after all, it was a "German view", and this was no trivial stigma in the 1920s and in the following decades. It is significant, however, that the "balance of payments theory" of the hyperinflation was held also by some distinguished scholars - unsuspected of unorthodox or Germanophile leanings - such as, for example, John Williams and Frank Graham in the and Bertrand Nogaro and Charles Gide in France5. Yet, these and other defenders of the balance of payments theory have not actually succeeded in providing a comprehensive and clear alternative to the "English" explanation, mostly because the connection between inflation and the burden of an impossible transfer, or from deep external imbalances, was not explored in a convincing manner. The transfer debate, represented for example by the celebrated Keynes-Ohlin exchange, was more or less divorced from the discussion of the origins of the hyperinflation and rapidly evolved towards issues solely of theoretical interest. It is significant as an indication of the omission of any link between adjustment and inflation that, for example, it was often argued during

3 L. Taylor(1986) p. 1. 4 On this debate see K. L. Holtfrerich (1986), G. Merkin (1982), C. P. Kindleberger (1984) pp. 310-311, K. E. Born(1977) and M. de Cecco (1983). 5 See G. Merkin (1982) for a more comprehensive listing. See also J. Williams (1922) and B. Malamud (1983). 10 the early transfer debate that the adjustment necessary for the transfer of reparations required reductions in the "standard of living"6, but the fact that the capacity of workers to resist such endeavors could make adjustment more difficult and could have serious inflationary repercussions is barely mentioned. This is somewhat surprising since there were strong reasons to believe that workers' capacity to resist cuts had been enormously increased by the early 1920s for a number of reasons. This might have been very important, as far as hyperinflations were concerned, for external shocks under "rigid" real wages can have very serious inflationary repercussions7. Possible wage rigidities were hardly mentioned in the hyperinflation debate; a possible role for wages was only briefly mentioned in 's review of Bresciani-Turroni book8 and much more recently in an entirely different context by Karsten Laursen and Jørgen Pedersen9. The wage issue, in fact, is one of many possible links between external adjustment and inflation; it has been extensively researched in connection with the experience of the 1980s and there is no reason to imagine it less relevant in the 1920s. The victory of the "English" view was by no means exclusively an outcome of the academic debate. The notion that the problems faced by Germany and other troubled economies in the aftermath of the war were purely financial, or that "fundamental imbalances" would be automatically corrected as soon as the adjustment machinery of the gold standard was restored, would come to play a very essential role in shaping policies of the core economies towards the reconstruction of the international economy and their specific attitudes towards the stabilizations of individual countries. These attitudes resulted very damaging especially in the cases of the new Central European republics created in Versailles - three of them experiencing hyperinflations. These economies would face extraordinary problems of adjustment to their new frontiers and economic realities, which would be completely ignored by authorities conducting the process of international stabilization and judging on stabilization loans and related conditionality. The sequel of this overemphasis on "sound finance", and related laissez faire notions, was to preserve a

6 Nowhere more dramatically and persuasively than in the original entry in this debate, namely J. M. Keynes (1920). 7 See, for example, L. Taylor (1979), W. H. Branson & J. J. Rothemberg (1980); T. Gylfason & A. Lindbeck (1984); E. Bacha & F. L. Lopes (1984); A. Canavese (1982); S. G. Turnovsky (1979); F. Modigliani & T. Padoa-Schioppa (1978) and more specifically in this context C. P. Kindleberger (1985). 8 J. Robinson (1938) p. 510. 9 K. Laursen & J. Pedersen (1964). 11 substantial degree of non-adjustment which would result disastrous a few years later when the abundance of foreign loans, which was to a great extent responsible for the maintenance of the gold standard in these countries, came to an end. The lesson was shown to be learned many years later, at the aftermath of the Second World War, as it was clearly perceived that the solution for external imbalances was an essential pre-requisite for stabilization and for the rebuilding of a healthy world economy. Yet, this demise of "sound finance" in the years of high Keynesianism would last little, as just a few years later the Bretton Woods institutions could be found preaching "sound finance" just as if nothing had happened. Conflicts regarding the emphasis on "structural adjustment" and financial issues as pre-requisites to stabilization and adjustment would be present during these years and even more clearly after the oil shocks and the . Meanwhile, in the academic world the apparent victory of the "English" view would be reinforced in the late 1950s by the publication of Cagan's seminal work at the onset of the monetarist counterrevolution10. The empirical stability of the money demand relationship would play a pivotal role in establishing the new monetarist paradigm and Cagan's study was possibly the most impressive and the most important contribution in this respect. With the increasing popularity of the new theory, and eventually with the incorporation of major elements of the new paradigm into , Cagan's study was raised to the position of the established view on the hyperinflations. Yet, Cagan's model does not seem to enjoy consensus when applied to "ordinary" inflations. It is quite curious that most economists with pragmatic views on inflation seem to feel comfortable with Cagan's model only when considering hyperinflations. The experience of the early 1980s did much to blur the frontier between what should be conceded to pure and what should be explained by other influences. In general the attitudes about the semi-hyperinflations of the 1980s have been careful and ambivalent; very few really attributed these inflations exclusively to money creation or seigniorage collection motives. This is not merely a product of economists celebrated pragmatism: the external shocks of the 1970s and 1980s have been flagrant enough. If the semi-hyperinflations of the early 1980s have been generated to a great extent by non monetary shocks then it is perfectly conceivable - in light of the extensive list of suggestive similarities between the 1970s and the 1920s, including large transfers, debts, external 12 shocks, flexible exchange rates and high inflations11 - that the latter might have played a very important role in the 1920s.

1.1.2) Stabilizations More important, as a practical matter, than the origins of the hyperinflation is the making of stabilizations. It is very essential to note in this connection that the knowledge of its fundamental causes might not be all that is necessary to explain the end of the hyperinflations. This was a crucial insight of the 1980s: since high inflations display a markedly auto-regressive character - the "inertia" phenomenon - the transition to stability was made difficult by the fact that, at any moment, the rate of inflation was to a great extent pre-determined. The nature of inflationary “inertia” is a crucial issue for the effectiveness of stabilization policy especially as far as high inflations are concerned. It generally involves an unclear mix of institutional factors, uninformed expectations and strategic interaction. The failure to deal with "inertia" issue seems to be the cause of the repeated failures of "orthodox" stabilization programs in the high inflation environment. Solving "fundamentals", in itself, usually does little to dissolve inflation, which is maintained by mechanisms such as backwards looking indexation, staggered contracts and problems related to coordinating wage and price restraint. By the same token, the successive failures of the so called "heterodox" stabilization programs in Latin America in the early 1980s left clear that addressing the "inertia" issue alone provides but temporary success if "fundamentals" are not addressed. In sum, the experience of stabilizing high inflations in the early 1980s has led most observers to agree that the problem of stabilization has a dual nature, it involves both "fundamentals" and "inertia", none of which sufficient in itself to assure a successful stabilization. The sudden ends of the hyperinflations are perhaps the most extraordinary episodes of ever registered. This is a basic and trivial consequence of the fact that in a fully dollarized economy - like the hyperinflation economies came to be - domestic inflation becomes identical, or at least very close, to the rate of depreciation, so that with the fixing of the exchange rate inflation stops instantaneously. The process of

10 P. Cagan (1956). 11 See for example T. Balogh & A. Graham (1979), R. Aliber (1980), J. A. Frenkel (1978) and A. Fraga (1984). 13 dollarization plays, of course, a crucial role in acting as a coordination mechanism governing all pricing and wage setting decisions in the economy. It should not be seen only as the extension of the use of foreign as inflation hedges; it advances as an extension of the indexation experience - or the reckoning of real values in terms of an index - that gains an extraordinary impulse in high inflation conditions. Dollarization basically means that the function of the national money is surrendered to the exchange rate, thus effecting a de facto coordination of all pricing decisions around one single index, which was exactly what allowed such extraordinarily sudden ends to the hyperinflations. The more recent explanation for the sudden end of the hyperinflations, have focused on a quite different mechanism. Thomas Sargent has argued that the sudden disinflation was determined by drastic, sudden and synchronized collective revision in expectations determined by fundamental changes in assuring the end of inflationary finance12. Despite the fact that Sargent does not offer much documentation on the nature of fiscal measures taken in order to support his claim, his explanation for the stabilization has come to play, as regards the understanding of the stabilizations, a role similar to the one played by Cagan's model as regards the causes of the hyperinflations: it is by no means accepted as a general picture of stabilizations though accepted up to a certain point as appropriate to the "extreme" cases13. The mechanisms underlying the stabilizations are the most important single issues for policy-makers of our days. It is easy to see, upon a close examination, the stabilizations as produced by a combination of many factors. They involved the development of dollarization as a mechanism to dissolve "inertia", a solution for "fundamentals" - which included usually the transition to a manageable fiscal position and measures towards external imbalances, such as debt rescheduling, large external loans and even additions of territory - and also more usual demand management policies. There is no reason to presume that any one of these elements would suffice to account for stabilizations; the great policy achievement was the engineering of this combination.

12 T. Sargent (1982) p. 57. 13 Moderate versions have been recently offered in which some of the assumptions are relaxed but the most important ones, namely those referring to "fundamentals" and to the way the "inertia" problem was solved are basically the same. See for example R. Dornbusch(1985) and S. Webb(1985a). 14 1.2) Plan of the work

This work attempts to reconsider the fundamental determinants of four of the hyperinflations of the 1920s - Austria, Germany, Hungary and Poland - and also the process by which such inflations were terminated. These hyperinflations evolved in a very similar historical context and provide vast material for comparative analysis. Other hyperinflations, such as the ones after World War II for example, took place in entirely different circumstances and it would require a major effort only to set up the proper context in which to compare these experiences with those of the 1920s. This is also true for the hyperinflation in the Soviet Union in the early 1920s for it was simultaneous with the most critical phase of the process of transition to socialism. The Soviet case seems a fascinating research project, but the issues involved are very specific, at least in the sense that it adds little in terms of comparative analysis. This work is divided into two parts: the first, comprising Chapters 2 to 6, is concerned with the historical context and the determinants of inflation and the second, that includes the remaining chapters, addresses different aspects of the stabilization experience. The work is oriented towards major issues - as opposed to a chronological or country specific presentation - and its purpose is basically to select issues relevant for the discussion of the current high inflation experience, or to draw lessons of a more general interest. In this connection, much attention is devoted to the definition of the proper historical and institutional context so as to control for these factors in drawing such lessons. That, on the other hand, might result troublesome for the reader unfamiliar with these countries histories as far as distinguishing dates and places in four different countries is concerned. In this regard the next section brings brief chronologies of events and charts with the postwar evolution of inflation in all four countries. Within the first part, the first two chapters are historical while the other two are essentially analytical. Chapter 2 starts from a broad perspective offering an account of the attitudes prevailing in the 1920s as regards external imbalances and financial issues in the context of the problem of international reconstruction and stabilization following the First World War. It is argued that the assumption that the rebuilding of the gold standard would suffice to restore external balance on each individual country and a healthy world economy was the basic guideline for international action towards the stabilization of the 15 hyperinflation economies, and that it resulted in preserving imbalances to be uncovered only later in the 1920s when the international lending bonanza came to an end. The contrasts with the experience of adjustment-stabilization following World War Two is very rich and it is briefly discussed to illustrate the shift in emphasis towards structural adjustment vis à vis "sound finance". Chapter 3 is more directly concerned with specific imbalances present in the hyperinflation economies. These problems are shown to stem mostly from the Peace Treaties, which redrew the Central European map according to criteria that were only partly informed by the economic viability of the new countries. The German problem is shown to be of a different nature, namely related to the payment of reparations. It is argued that the burden of reparations was indeed very heavy - thus challenging the analysis of a number of authors - and turned even harder by the determination of a considerably strengthened labor movement not only in resisting wage reductions but also in recovering pre-war levels of real wages. This "inconsistency" should be seen as a major factor in generating inflation, as explored in great detail in Chapter 5. Chapters 4 and 5 are mostly concerned with alternative models for the determination of inflation. Broadly speaking, they attempt to assess the explanatory power of models typical of the different "schools of thought" on the determination of hyperinflation. Chapter 4 discusses monetary models of high inflation and their application to these specific episodes. The evidence presented - mostly related to the patterns of seigniorage collection in these episodes - leads to the basic conclusion that non-monetary influences seem to have played the dominant role, or that money played a passive role in these episodes. In Chapter 5 a model is developed highlighting the inflationary repercussions of adjustment problems under wage rigidities - or the "vicious spirals" created by inconsistencies between the requirements of external balance and the demands of the labor movement - in the presence of flexible exchange rates and inflationary inertia. No claims of generality are made with respect to this model, though it is indeed argued that it describes very well these hyperinflation experiences in their very historical context. A crucial feature of this model is that inflation is not explosive, it cumulates shocks onto a process with "memory", which is indeed the case of all episodes, excepting the last four months of the German inflation when something of a different nature seemed to interfere with the dynamics of inflation, namely the introduction of indexed monies, as seen in 16 Chapter 10. The second part of this work - treating the process of stabilization - comprises a discussion of the advance of indexation and dollarization as a vehicle for the solution for the inertia problem and also an analysis of the difficulties in handling "fundamentals" in each case. Chapter 6 starts by providing documentation on the historical and institutional issues involved in the adoption of indexation in the hyperinflation environment and how this process degenerated into a process of dollarization. As a prelude to the more detailed treatment of each individual stabilization case in the following chapters, Chapter 6 develops an application of the model of Chapter 5 to illustrate the basic mechanisms underlying the individual stabilizations. It discusses the effects of fixing the exchange rate under dollarization, the choice of parity to be defended, the behavior of wages and international reserves, and the role played by external loans and also by fundamental improvements in the country's external position, which could allow the reconciliation of target wages and external balance. Chapter 7 plays a very important role in this work for it complements Chapter 4 in providing a case against the Cagan & Sargent view of the hyperinflation episodes. Chapter 7 examines in detail the fiscal "reforms" that were implemented during the stabilizations and discusses their role in reordering these countries finances. Its basic findings include the fact that inflation influenced tax collection to such an overwhelming extent that price stability by itself would bring budgets to a near balance and in some cases even to a surplus. It is also shown that, even for the countries subject to the Draconian discipline of the League of Nations intervention, expenditure cuts played a minor role for balancing these countries budgets. For Poland in particular the stabilization was not even accompanied by budget balance; much on the contrary sizeable deficits financed by money creation were observed and this did not seem to interfere with the stabilization. In light of this evidence, Chapter 7 questions the role actually played by fiscal "reforms" in these stabilizations for the "inflation-corrected" deficits seemed either very small or outright inexistent. The next three chapters refer to the final act of each stabilization episode, thus focusing on events associated to the fixing the exchange rates, its effects and the mix of measures taken to sustain the exchanges. Austria and Hungary are considered together in Chapter 8 for in both cases a large loan under very strict conditionality sponsored by the 17 League of Nations was the key aspect of the stabilization. Given that the fiscal problem was solved by the effect of price stability on tax revenues, there lacked, as regards "fundamentals", a "permanent" improvement in these countries' balance of payments necessary to reconcile external balance with the demands of the labor movement. This role would be played by the large stabilization loans floated under the League auspices and the inflows of foreign capital that followed. In both cases real wages would recover very quickly after the stabilization, as "predicted" by the model of Chapter 5, and the implied deterioration in competitiveness, and the associated development of a large current account deficit, could be accommodated by continuously borrowing abroad. For Hungary in particular it is argued that the authoritarian government that ruled during the 1920s created the possibility of blocking the recovery of real wages, an option unavailable to the other countries. The key issue for these countries was how to address the structural problems created by the new frontiers when the League's priorities were only associated with financial issues; the tensions between austerity and adjustment are very clearly observed, especially in Austria. For Germany and Poland it is also true that the access to international capital markets in the second half of the 1920s was the factor that allowed the reconciliation of wage demands and external balance with no resort to . But in both cases the stabilization was accomplished before foreign capital was made available in significant amounts, and in both cases special circumstances would explain that. The Polish experience discussed in Chapter 9 differed from the ones under the League control mostly by virtue of the priority assigned to investment spending connected to issues of strategic interest (railways) - seen as essential for nation-building and political balance in the region - from which one explains the lesser importance given to budget balance. Probably in view of this, the Poles access to foreign finance was reduced. Just like the other countries, however, real wages in Poland recovered very significantly after the stabilization, producing a deterioration in the current account that slowly eroded international reserves leading the zloty to float one year and half later. Only then, when the hyperinflation was no longer an issue, the Poles could successfully float a large stabilization loan and enter the borrowing bonanza of the late 1920s. Their previous concern with adjustment, however, would make Poland much less vulnerable in the late 1920s than the League countries to the vagaries of the international economy; Poland withstood the shocks of the late 1920s 18 without even abandoning the gold standard. The German stabilization, treated in Chapter 10, is surely the most fascinating case, which is mostly due to the rentenmark experiment. Chapter 10 devotes special attention to the experience with the "stable valued currencies", or "indexed monies", in Germany and its consequences. It is argued that the dissemination of such monies determined, on one hand, the inflationary explosion observed after June of 1923, but opened up, on the other, the possibility of a large issue of an official "indexed money" which came to be the rentenmark . Thus, Chapter 10 offers a solution for the old enigma of why the rentenmark was accepted as hard currency despite its having no real “backing” in foreign currencies or gold. The rentenmark would play an essential role to the effort of fixing the exchange rate while the reparations issue was unsettled; it would work just like a external loan that would accommodate the deterioration in the current account provoked by the sharp recovery in real wages observed after the stabilization. Chapter 10 discusses the role played by other factors - interest rates for example - and also alternative view on the German stabilization. No overall conclusion is actually offered; only a brief "moral" of the story is given in the epilogue.

1.3) Chronologies

1.3.1) Austria

1918 November . Austrian Republic established. 1919 March . Stamping of Austro-Hungarian banknotes within new Austria. Socialist Foreign Minister Otto Bauer offers to Germany an immediate monetary union. Schumpeter . June . First draft of Peace Treaty (St.-Germain-en-Laye) handed to Austrian delegation establishing reparations liability, new frontiers, of Empire's debt and liquidation of . September . Final text of Peace Treaty. Cabinet fell, Schumpeter and Bauer resigned. November . Renner government proposes introduction of partial wage indexation. December . Chancellor Renner's appeal to the Supreme Allied Council for financial help denied. 1920 February . Austrian Section of the Reparations Commission established. June . Socialist withdrew from Cabinet, and capital levy waived. 1921 January . "Goode Scheme" proposed by Reparations Commission. March . Chancellor Mayr appeals to Supreme Allied Council for financial help under Ter Meulen terms. June . League of Nations' experts report of Austrian stabilization prospects. July . Paris edition of the Chicago Tribune announces breakdown of League plans causing panic in Vienna. October . Socialists(Otto Bauer) present plan for reconstruction. November/December . Food subsidies mostly abolished. 1922 February . British government extends a credit of £2.0 million to Austria. May . Empowered conservative chancellor Ignaz Seipel. August . Seipel appeals to the Allies for financial help. Lloyd George refers the matter to the League of Nations' Financial Committee to elaborate scheme based of 1921 experts' report. 19 October . Protocols defining League scheme signed at Geneva. November . Emergency powers law passed by Austrian Parliament. November/December . Austrian banks subscribe internal loan. December . Commissioner-General arrives at Vienna.

Chart 1-1 Austrian inflation: 1919-1923 (monthly rates)

SOURCE and OBSERVATIONS: For 1919-1920 figures are for exchange depreciation, for 1921-1923 figures are for inflation computed from retail prices. From J. van Walré de Bordes(1924) pp. 82-83,115-117.

1923 January . New bank of issue starts operations. February . £3.5 million short term advance over reconstruction loan placed. March/June . Reparations Commission and holders of relief bonds suspend all liens on Austrian property. June . Reconstruction loan floated.

1.3.2) Hungary

1918 October . Hungarian independence. 1919 March . Bolshevik government under Bèla Kuh. June . Romanian invasion. August . Right wing government established under Admiral Horthy. September . Final text of St. Germain-en-Laye Treaty establishing new frontiers, reparations obligation, distribution of Empire's debt and liquidation of central bank. 1920 March . Stamping of Austro-Hungarian notes within Hungary and attempted stabilization through confiscation of notes. November . New stabilization attempt under finance minister Hegedüs. 1921 June . Hegedüs resigned. 1922 October/December . Exchange rate stabilization attempted by exchange control institute. 1923 April . Appeal to the Reparations Commission to raise liens on Hungarian property. September . League of Nations asked to start preparatory work for financial reconstruction. October . Reparations Commission officially invites League to draw stabilization plan. November . League's experts in Budapest. December . Experts report to Financial Committee of the League.

20

Chart 1-2 Hungarian inflation: 1919-1924 (monthly rates)

SOURCE and OBSERVATIONS: Figures are for wholesale prices from E. A. Boross(1984) pp. 224-226 and L. L. Ecker-Rácz(1933a) pp. 61-62.

1924 January/February . Collapse of Vienna Bourse transmitted to Budapest generating . March . League delegation in Budapest to draw reconstruction law. Protocols defining League scheme signed in Geneva. April . Reconstruction Law adopted by Hungarian government. Advance from Hungarian banks to government. Subscription of new bank of issue opened. May . Commissioner-General arrives in Budapest. Forced domestic loan. June . New bank of issue starts operations. July . Reconstruction loan floated.

1.3.3) Poland

1918 November . Polish independence. 1919 May/September . Versailles and St. Germain-en-Laye Treaties establish new frontiers, Dantzig as a "free city", and plebiscites to be held in Upper Silesia and East Prussia. November . Currency unification, creation of the Polish mark. 1920 Polish Soviet war. 1921 March . Peace of Riga (between Poles and Soviets). November . Attempted stabilization under finance minister Mich alski. 1922 June . Upper Silesia annexed to Poland. Michalski resigns. 1923 January . Conference of former finance ministers. August . Sejm passes law creating capital levy. October . British financial expert E. Hilton Young invited to report on Polish finances while loan negotiations taking place in London. Compulsory wage indexation law introduced. December . Grabski cabinet empowered. Wage indexation law passed. 1924 January . Reconstruction() law passed. Domestic indexed loans floated. Subscription of new bank of issue opens. March . Italian loan floated. April . New bank of issue starts operations. 21 1925 March . Loan floated in the US under Dillon, Reed & co. June . war with Germany. Short-term credits obtained from the Federal Reserve Bank of New York. July . Zloty allowed to float. November . Grabski resigns and is replaced by Zdziechowski.. December . First visit of American financial expert Edwin Walter Kemmerer. 1926 May . Pilsudski coup. June . Kemmerer's second visit. 1927 October . Stabilization loan floated.

Chart 1-3 Polish inflation: 1921-1924 (monthly rates)

SOURCE and OBSERVATIONS: Figures are for cost of living in Warsaw from Republic of Poland(1924) p. 89 up to June of 1922; from then on prices are wholesale from J. P. Young(1924) vol. II p. 349.

1.3.4) Germany

1920 January . Versailles Treaty ratified by Allies. March . Fiscal reforms and attempted stabilization under Erzberger. Kapp putsch defeated. 1921 May . London Ultimatum fixes reparation obligation. August . Former finance minister Erzberger assassinated. 1922 April . Genoa Conference. Raymond Poincaré new French chancellor. May . German government asks a moratorium for reparations payments. June . Foreign minister Walter Rathenau assassinated. Plans of foreign loan under J. P. Morgan failed. August . Reparations payments suspended. November . Keynes/Cassel report on German finances. 1923 January . French and Belgian troops invade the Ruhr. March/April . Reichsbank intervention keeps exchanges stable. First gold loan issued. August . Hilferding Finance Minister. Second gold loan issued. October . Luther Finance Minister. Third gold loan issued. Government proposes gold wage system. Attempted tax indexation. Civil personnel reduction decree. November . Rentenmark introduced, exchanges and prices stabilized. Schacht appointed president of Reichsbank. Committee of experts appointed (Dawes Committee) by the Allies to report on Germany's "capacity to pay" reparations. Hitler's Beer Hall Putsch defeated. 22 December . Reichsbank refuses accommodation for Treasury bills. Emergency fiscal ordinances. 1924 January . Schacht visits Montagu Norman and Gerhard Vissering and gets support for Goldiskontbank. First meeting of Dawes Committee. April . Credit enforced. Golddiskontbank founded. Dawes Committee presents scheme for rescheduling of reparations and foreign loan. June . Dawes report officially approved. October . Dawes loan floated.

Chart 1-4 German inflation: 1919-1923 (monthly rates)

SOURCE and OBSERVATIONS: Figures are for wholesale prices from J. P. Young(1924) vol. I p. 530.

Table 1-1 Germany: Inflation rates in the "explosion" phase ,1923 (monthly rates)

month CPI Wholesale prices April-June† 44 67 June 100 132 July 395 221 August 1,459 1,208 September 2,460 2,035 October 24,280 24,432 November 17,865 8,600 . † monthly averages for the quarter. Source: C. L. Holtfrerich (1986) pp. 24-33. 23

Part 1: The “fundamentals” of inflation

Chapter 2

Origins and factors for hyperinflations 2.1) Introduction

This chapter discusses from a broad perspective the policies and assumptions underlying the actions towards the problem of reconstructing the international economy in the 1920s and more specifically the nature of the adjustment problems to be addressed in the countries to face hyperinflations. It starts, in the next section, from the conventional observation that the adoption of the practices and rules developed during the pre-1914 gold standard as the basic point of reference for stabilization policies revealed that the authorities of the time failed to assess the extent to which the pre-war "normalcy" had been permanently destroyed. The most obvious consequence of such assumptions was to assign an excessive emphasis to the financial aspects of the stabilizations in detriment of more substantial forms of adjustment. This is clearly revealed by the efforts of concerting international action conveyed by the international financial conferences of the time. The excessive emphasis on finance would result in preserving a substantial degree of non-adjustment during the 1920s, especially in the few countries subject to fundamental and adverse changes in their economies, i. e. their frontiers and external positions. By and large, however, these disequilibria could be sustained, as suggested in section 2.3, in view of the abundance of foreign capital observed during the second half of the1920s, which allowed otherwise painful restructuring processes to be evaded. Indeed, all the hyperinflation countries, with the obvious exception of the Soviet Union, became heavy borrowers in international capital markets after their stabilizations. Borrowing was certainly not a solution it itself as changes, reconstruction and dislocations in these countries competitive positions required investments addressing the needs of adjustment. Thus, the medium run viability of such indebtedness trajectory would depend on investment activity, or on the allocation of foreign capital to uses conductive not only to the repayment of loans but also to the solution of original imbalances. This is actually where one finds a very significant contrast between the 1920s and the experience of reconstruction following World War II. The stabilization loans of the 1920s served mostly to recompose international reserves so as to allow a return to the gold standard, and the ensuing capital inflows did not seem to be committed to any sort of adjustment effort. After World War II the large capital inflows under the Marshall Plan were specifically addressed to investment needs related to the elimination of Europe's dollar deficit. The contrast between the two experiences is extraordinary and the outcomes of the two episodes, the collapse of the 1930s and the long prosperity of the 1950s and 1960s is by no means independent from the reconstruction strategies following the respective wars. The last section offers a brief comparative discussion of the post World War II international stabilization experience.

2.2) Stabilizations in the 1920s: an international perspective

During the first half of the 1920s most of the problems directly related to the war, such as the rehabilitation of the devastated areas and the reconversion of economies to peacetime patterns, had already been resolved; but this by no means implied that economic life in Europe had been normalized, and even less that the pre-war levels of production and productivity had been regained. Indeed, as late as in 1927 the Geneva International Conference would sadly recognize that "the dislocation caused by war was immensely more serious than the actual destruction"1. Three sorts of dislocations would present challenges to postwar planners. First, the financial legacies of war finance in the belligerent countries appeared to many commentators as an essential obstacle for economic stability in Europe. Second, the peace settlements had originated entirely new problems, such as, for example, the adjustment to the new frontiers in Eastern Europe, and the collection of reparations. Third and less apparent than these, a number of problems of a more structural nature related to the position of European economies within the world economy started to be increasingly felt during the 1920s. These problems had been partly generated by permanent changes determined by the war in the geographical distribution and commodity composition of international , notably by the spread of industrialization outside Europe and by the ascendancy of the US and Japan; they were also due to longer term developments related to the pattern of technological innovations vis à vis existing industrial structures in some European countries2. These problems, whose perception and assessment was variable among

1 H. Clay (1957) p. 225. 2 I. Svennilson (1954) pp. 22-25. observers, constituted the core of the international stabilization problem that would challenge policy-makers for the whole decade. Those of the first group, i. e. the financial problems, have been most usually emphasized, which expressed the fact that the usual attitude towards the issue of rebuilding the European economy was that it involved mostly a problem of monetary stabilization rather than the redefinition of whole new international economic order. The much professed "return to normalcy" provided actually a powerful indication of the latitude of the assumption that the pre-war status quo had not been fundamentally changed; it was implicitly assumed that issues as reparations and war debts would eventually find a satisfactory diplomatic settlement, so that except for disorderly finances, nothing would prevent the restarting of economic life where it stopped in August of 1914. The usual verdict about the stabilizations of the 1920s was that they were "from the international point of view, a piecemeal process carried out by one country after another in a completely uncoordinated manner"3. There followed, for instance, that "the pattern of exchange rates that emerged was hardly consistent in the sense of allowing the constituent parts of the world economy to experience normal rates of growth at reasonably high levels of employment without balance of payments difficulties" 4. It was generally agreed that a "simultaneous and coordinated international action" 5 could minimize the strains to which the international economy would be exposed along the process, but such course of action had been explicitly scorned by the leading authorities of the time, which seemed to favor a “country by country approach” 6. Though something along these lines effectively took place in a limited scale as regards central bank cooperation 7, constraints like the US isolationism and the uncertainties in European diplomacy, especially as regards Germany, considerably reduced the scope for international policy coordination.

3 LN (1944) p. 116. 4 D. E. Moggridge (und.) p. 37. 5 LN (1944) p. 117. 6 Benjamin Strong, influential president of the Federal Reserve Board, explicitly favored a "country by country approach" in opposition to a "general scheme", as countries differed in the degree to which they adhered to what he deemed the fundamental conditions for currency stabilization, namely balanced budgets, moderate currency inflation, small government debts, a "sound" bank of issue, a fairly large and a "reasonably well balanced foreign trade". Cf. L. Chandler (1958) p. 281. Although uncoordinated, the international stabilization experiment during the 1920s was not chaotic; the observation of individual instances clearly reveals common guidelines and procedures that, as long as the overall experiment was concerned, would characterize, at least ex-post, a well defined stabilization strategy. This "strategy" was largely dominated by the authority of the practices and institutions of the pre-war gold standard, whose reconstitution at an international level quickly became the crux of the international stabilization problem; a symbol of the pursuit of the lost normalcy. Doctrinal and considerations were important to establish the target of reconstituting the gold standard 8 as easily demonstrated in the proceedings of the international monetary conferences of these years - Brussels and Genoa. The Brussels Financial Conference in 1920, for instance, was mostly oriented towards the principles based on which individual stabilizations should be undertaken. It is significant in this respect that some concrete steps were taken as regards international credits under the so-called Ter Meullen plan, which would develop later into the League of Nations plans for Austria and Hungary. The Conference, however, was very superficial on issues other than financial. This was not entirely due to some doctrinal overemphasis on financial remedies, which certainly existed; issues like reparations and war debts had been withdrawn from discussion much under French request, thus reducing considerably the scope for more substantial resolutions 9. The Conference's report proclaimed, however, that its members "were conscious that, limited to the sphere of finance both their terms of reference and their personal qualifications they could only deal with a part of the problem that faced the governments and the peoples of the world. Finance is after all - the report continued, only a reflection of commercial and economic life - a part only, though an essential part of its mechanism" 10. But the realities of the international stabilization problem would eventually reveal that behind these careful disclaimers the general attitude of those involved in the problem was that most fundamental imbalances would be mostly self-corrective provided that "sound" financial conditions prevailed. In general there was a deep faith on the balance of payments

7 S. V. O. Clarcke (1967) and B. Eichengreen (1984). 8 S. V. O. Clarcke (1973) pp. 11-13; F. Costigliola (1977) pp. 914-915; D. P. Silverman (1982) pp. 50-61 and D. E. Traynor (1949) pp. 136-139. 9 D. P. Silverman (1982) pp. 275-276. adjustment mechanisms implied by the gold standard, largely emanating from Britain 11. The Conference, in its resolutions and also in the Joint Statement of the Experts 12, strongly reaffirmed the need for balanced budgets, for the funding of floating debts13, for "inflation of credit and currency" to be ceased, for central banks independent from governments - which should be established where still inexistent - to conduct business on the basis of "prudent finance" and avoid “artificially low bank rates, out of conformity with the real of capital” 14. The experts' account, certainly influenced in this point by Cassel's contribution, included the notion that "the level of exchanges tend to correspond with relative internal values of currency of the several countries", thus offering a solution for the issue of the choice of parities, which would be more fully developed in Cassel's "Memorandum on World's Monetary Problems" presented in the conference15. The stabilization programs implemented under the League of Nations auspices in Austria and Hungary provided a clear and direct illustration of such attitudes. In Austria, for example, the League's experts explicitly recognized that apart from the financial problems "there remains the problem of the fundamental economic position of Austria", which, however, they saw as related to the Austrian balance of payments and consequently outside their province16. Their judgment was that "if the appropriate financial policy is adopted and maintained, the Austrian economic position will adjust itself to equilibrium, either by the increase of production and the transfer of large classes of its population to economic work, or economic pressure will compel the population to

10 LN (1920a) p. 9. 11 D. E. Moggridge (und.) p. 22. 12 The five experts presenting individual memorandums and signing a joint statement were Gustav Cassel, A. C. Pigou, Charles Gide, M. Pantaleoni and G. Bruins. 13 Though these recommendations have been somewhat vague for countries undertaking reconstruction of devastated areas, cf. LN (1920a) p. 22 and D. E. Traynor (1949) pp. 46-47. 14 Idem, ibid. Our emphasis. 15 In LN (1920b), and later reproduced in G. Cassel (1921). See especially pp. 44-48 of the earlier edition, or pp. 36-49 of the later one. 16 LN (1926a) p. 186. They argued that "Austria cannot permanently retain a sound financial position, even if she attains it for the time, and to maintain her present population, unless her production is so increased and adapted as ... to give her equilibrium also in her ... all possible measures, whether by the amelioration of the international economic relations, the encouragement of the conditions which would increase Vienna's entrepot, financial and transit business, and those which will attract further private capital towards the development of her productive resources are therefore, of the greatest importance". emigrate or reduce it to destitution" 17. Quite the same laissez-faire approach was adopted by the League in Hungary. As in Austria it had been established that the League action "should be definitely and expressly limited to remedying the budgetary, and therefore the financial position" and although they argued that "this is not to suggest that the Committee considers the economic restoration as of secondary importance, nor even that the League itself can do nothing to assist it", their point was that "the necessary economic adaptation must be effected by Hungary herself" 18. The experts notwithstanding left clear their thoughts on the nature of the "adaptation" program by arguing it should consist, on one hand, of an effort to conclude commercial treaties with the countries in the Danubean area to which the League would actively contribute, and possibly remove unilaterally its trade restrictions19. On the other hand, as far as domestic adjustments were concerned, the experts were mostly vague and when they ventured to say something they paid lip service to conventional textbook liberalism by criticizing Hungarian efforts to foster industrialization20. In any event, the League schemes thus defined have been generally considered - for example by Montagu Norman, certainly one of the most influential personalities of these years - as a recipe to be freely administered to the distressed economies of Central Europe21. This laissez-faire approach would seem especially clear as regards attitudes towards trade imbalances. Cassel, for example, was voicing mainstream ideas when argued that trade imbalances would be largely self-corrective, since with the appropriate choice of exchange rates the "adverse balance of trade" would be but a temporary

17 Idem, ibid. 18 LN(1926b) pp. 56-57. 19 Ibid. pp. 75-76. 20 According to the experts' report, "the most vital thing for Hungary is that she should achieve the best production of - and find markets for - the products for which her natural resources and her natural aptitudes best fit her. To the extent to which she diverts her resources in labor and in capital to producing what can be more cheaply obtained from abroad at the expense of what she can produce better than other countries there must be a net economic loss". Idem, ibid. 21 In a letter to Benjamin Strong of April 9th, 1922 speaking of the good prospects of the floatation of the Austrian loan, Norman argued that "if we can thus set up Austria, we must tackle Hungary so as to establish one by one the new parts of old Austria ... and perhaps the Balkan countries. Only by thus making the various parts economically sound and independent shall we reach what I believe to be the ultimate solution for Eastern Europe, viz. an economic federation to include half a dozen countries in or near the Danube free of custom barriers, etc." . Cf. Henry Clay (1957) pp.189-190, emphasis in the original. phenomena22. This was a very significant expression of the faith on the "classic" balance of payments adjustment mechanism under flexible exchange rates (or under inconvertible paper currency) that had been mastered by Taussig and his students23. Capital movements, trade impediments and also wage "rigidities" were often mentioned as possible obstacles to this process, but the idea was that these problems would all disappear with the normalization of economic life24. Cassel was the origin of the notion that the appropriate procedure for choosing parities after 1918 would be to correct the 1914 parities by the rates of inflation observed in the interval25. Such widely employed procedure implicitly assumed that the real exchange rates of 1914 still secured external balance after the war, which was not necessarily true. It has been convincingly argued by Moggridge, as regards Britain, that the method was misleading to the extent that it failed to take into consideration the changes in the country's competitive position26. The procedure would be the more misleading the more a country had been "changed" in the meantime; for many Central European countries in particular, the procedure was entirely meaningless. In any event calculations have been extensively used during the 1920s, being actually one of many instances in which the assumption of the existence of a fundamentally undisturbed pre-war "equilibrium" was clearly taken for granted. The Genoa Conference in 1922 would reaffirm the principles and policy guidelines - the "pious platitudes" as put by Hawtrey27 - previously laid down in Brussels and extend them in several directions. Much weight was placed on the resolutions calling for active cooperation on independent central banks as regards issues as credit policies aiming at price stability and also joint actions as regards international credits28. This actually reflected the fact that central bankers had assumed a dominant position in the process of

22 G. Cassel (1922) pp. 163-186. 23 See F. W. Fetter (1968) for a review of these developments. 24 G. Cassel (1922) p. 165. 25 Cassel argued that, assuming an initial equilibrium position and that some inflation had occu rred during a period of time, an "adverse" balance of trade could exist only if the actual exchange rate was for some reason "overvalued" with respect to its purchasing power parity , or the real exchange rate was overvalued, Ibid. p. 166. 26 D. E. Moggridge(und.) passim. and (1969) pp. 69-75. 27 R. G. Hawtrey (1926) p. 122. 28 Ibid. p. 123, S. V. O. Clarcke (1967) p. 42 passim D. E. Traynor (1949) p. 82, R. S. Sayers (1976) p.157, H. Clay (1957) p. 223 and L. Chandler (1958) p. 285. international stabilization, performing a role their governments were reluctant to play; it also expressed the notion that the process should be conducted in a "technical" or "business-like" manner without the involvement of politicians29. For no other reason men as Norman, Strong, Schacht and Moreau played such an important role in these years. Second, in the name of preventing the scramble for gold reserves the conference proposed a pattern of distribution of international liquidity by means of which some financial centers, specifically London and New York, would become gold centers while others would hold their international reserves mostly as balances against these centers; this arrangement would become known as “the gold exchange standard” 30. The proposal was regarded as favoring British in detriment of other secondary financial centers, Paris in particular; conflicts in this account would be serious but would only be apparent by the late 1920s31. Third, the conference showed much more pragmatism as regards the fixing of exchange rates to the extent it proposed stabilizations close to the actual rates, which resulted in creating a favorable atmosphere for devaluations, at this point considered to be inevitable for many countries including and Italy32. Lastly, the conference attached much importance to the issue of financial help for countries with weak currencies and in this respect reproduced the Brussels concern about the guarantees and conditions under which such credits could be granted33. The Brussels solution, embodied in the Ter Meulen plan, of placing a "productive asset" under international administration proved too stringent and did not attract any borrowers. Much under the influence of Norman and Strong the notion of conditionality, or "control", as it was called at the time, evolved towards the idea that countries undertaking stabilization should be given support in the form of credits, provided that "sound" policies were adopted and that the credits were extended to the central bank and not to the

29 L. Chandler (1958) p. 286 passim. Norman specifically managed to carry the principles of central bank autonomy to extremes. According to Sayers "he was always glad to meet central bankers, but would refuse all contact with foreign ministers of finance or their officials: if some were in the same room when he met central bankers he would confine his conversation to the latter". Cf. R. S. Sayers (1976) vol. 1 pp. 159-160. 30 R. G. Hawtrey (1926) pp. 126-127, D. E. Traynor (1949) p. 82 and S. V. O. Clarcke (1973) p. 14. 31 Especially after the franc and the pound being stabilized, the French found themselves displeased with the obligation of holding a very large proportion of their reserves in the form of sterling. The French then increased the portion of their reserves held on gold, which resulted in putting London, and consequently the international economy, into great strains. LN (1944) chapter 4 passim. 32 D. E. Traynor (1949) p. 86 and S. V. O. Clarcke(1973) p. 15. 33 D. E. Traynor (1949) pp. 71-75. government34. Such attitudes, in view of the weight Norman and Strong carried, enormously influenced the behavior of private international banks. The account of a leading historian of this period is unambiguous in this respect35:

[a borrowing country] would usually have found impossible or at least very difficult, to float foreign loans if its stabilization program failed of approvals of Norman and Strong. In many cases the great international banking houses, such as Morgan's, Rothschild's and Baring's, refused to float stabilization loans if the borrowing nations central bank did not at the same time received a credit from foreign central banks. Norman's approval could almost assure a nation's ability to borrow in London; his disapproval could close the market for such loans. Strong's influence with New York investment bankers was great though less dominant. A former partner in Morgan's told ... that his firm would never float a loan that Strong disapproved, and that Strong's approval always weighted heavily. Strong's views were probably less influential with some of the newer and less conservative investment banks.

During the 1920s a definite and explicit link was established between the adoption of orthodox stabilization plans and the access to international credits. Very commonly bankers argued that they only imposed procedures that the borrowing countries would have to follow anyway if they aimed at stabilizing their currencies36. The presumption was that there has been no alternative outside the principles developed in Brussels and Genoa, and the reasons for that are not simple. Doctrinal considerations certainly played a part, as very often during the 1920s the authority of the "superior" financial practices and institutions of countries like Britain, for example, was confronted with the confused finances of continental Europe, not to mention those of Latin American countries. The choice of stabilization policies often involved the technical advice of foreign economists and financial "experts", a work that was described by one of the leading financial experts of the time as one of using "scientific imagination in the application of sound economic

34 L. Chandler (1958) p. 285. 35 Ibid. pp. 285-286. 36 According to Strong's biographer, Norman and Strong "believed that the requirements they imposed were only those that would have to be met in any case if the country was to succeed in restoring and maintaining gold payments", cf. L. Chandler(1958) p. 286. Similar arguments have been repeatedly made as regards the League schemes in Austria and Hungary, for which the protocols and conventions often remarked that these countries could not by any means have avoided undertaking the "comprehensive reforms" if the stabilizations were to be attempted, cf. LN (1926a) and (1926b). theory to unsound and often very strange economic practices" 37. The 1920s effectively marked the heyday of the "experts", an unambiguous reflection of the "business oriented" or "scientific" approach that Britain and the US had assigned to international stabilization38. The "money doctors" and their missions actually represented an important link in the expansion of international investment in this period, for they framed informed and detailed stabilization programs, sold domestically and internationally as "impartial" advice, on which international loans were made contingent39. Very often the borrowing countries took the initiative of calling such missions, not exactly because of the quality of the advice, as the recipe was old and well known, but because it impressed favorably international capital markets. Poland, for example, invited foreign experts to report on Polish finances in three occasions between 1922 and 1927, all of which related to the objective of securing international credits40. It has also been the case of most of the celebrated Kemmerer missions in Latin America during these years41. The "experts" of these years, despite the understandable bias towards conservative thinking, included professional economists of indisputable competence and reputation42. Yet not only the "technical" problem in itself was very difficult43, but it is important to observe that the problem of international stabilization was an important part of a process of redefinition of spheres of economic influence and political leverage44. The "comprehensive programs" prescribed by international bankers following the Genoa guidelines, served the overall purpose of rebuilding an international financial system

37 E. W. Kemmerer (1927) p. 5. 38 F. Costigliola (1976) and J. H. Wilson (1971) chapter 1. 39 As regards missions of experts in Latin America, see R. Seidel (1972) and P. Drake (1979). It is also interesting to see Kemmerer's account of his work in E. W. Kemmerer (1927) p. 5. 40 British expert Edward Hilton Young was invited in 1922 when the Polish government was seriously considering floating a loan in London. Later the Poles invited the peripatetic professor Kemmerer in two occasions, the first under influence of American bankers Dillon, Reed & Co, responsible for a large loan floated in New York in 1925. The second time, just after the Pilsulski coup in 1926 led eventually to the floatation of an international stabilization loan in 1927. Their respective reports are E. H. Young (1924) and Republic of Poland (1926a). 41 R. Seidel(1972) and P. Drake(1979) passim. 42 Keynes himself along with Cassel and some others was invited by the German government in 1922 to present an expert report on German finances. The mission reported in November of 1922 arguing that at that point the stabilization of the mark was possible "by means of Germany's own efforts" and remarked that the "success of any scheme of stabilization must depend not on a foreign loan but rather on industrial and budgetary developments within Germany", cf. L. L. B. Angas (1923) pp. 126-133. Unquestionably the report did not differ in nature and content from the several others manufactured by the priests of "sound money". 43 The fragility of the assumption that the "experts" were better equipped to understand the economic problems of the early 1920s is very convincingly exposed by Dan P. Silverman (1982) pp. 10, 41 passim. centered in London and New York. These programs seemed to fit well economies which had little policy autonomy to exercise, but would find decisive resistances in larger economies, such as France, Italy, Germany and to a certain degree Poland, for which a position of passiveness towards external developments, let alone subordination to London or New York, would be clearly inappropriate. Countries of the so-called “periphery” would seemingly do better on a more flexible setting, for example under some sort of managed floating with some scope for insulation; but the European experience with flexible exchange rates had not been very rewarding, and even at a domestic level the idea of managed money would have to wait another decade45. It is unfortunate, though, that recent scholarship has done much to perpetuate "the mythology of the superiority of Anglo-Saxon principles of sound fiscal, financial and monetary policies" 46, as for example in Stephen Schuker account of French finances47 or in the usual reference to the "economic illiteracy" 48 or the “intellectual failure”49 of German authorities. The disproportionate emphasis on "sound finance" and the laissez-faire attitudes of the leading financial authorities of the time would eventually result in leaving medium run adjustment problems to be solved by "market forces". This would mean that adjustment was mostly evaded by the countries with the most serious imbalances for these have become heavy borrowers in international capital markets. It seems natural to conjecture that the tragic outcome of the lending episode of the late 1920s could be associated with the fact that more fundamental adjustment problems were swept under the rug by the rebuilders of the gold standard. In this connection, some of the blame for the collapse of the early 1930s could be put on the ill conceived stabilization strategies of the early 1920s.

44 Ibid. pp. 41, 58 passim. 45 LN (1944) passim and D. E. Moggridge (und.) p. 19. 46 D. P. Silverman (1982) p. 53. 47 According to Schuker, "most of the French elite at the time were abysmally ignorant even of rudimentary principles of economics. A few specialists on the Paris law faculty ... were doubtless as sophisticated as any economist in the world. But the education of the Third Republic's governing class was oriented towards literature and the humanities. Economics simply did not figure as standard part of the curriculum. What little economics middle aged man in positions of responsibility remembered from their youth generally was irrelevant to monetary problems in the postwar world". Cf. S. Schuker (1976) pp. 45-46. 48 As in D. E. Moggridge (und.) p. 36. 49 LN (1946) p. 17. 2.3) Adjustment and Borrowing in the 1920s

The excessive amount of attention the authorities of the 1920s devoted to financial problems might have been effective to provide for a quick resolution of the financial legacies of the war, but did little or nothing on account of the more fundamental problems faced by Central European economies. Adjustment to post-war conditions generally required major sectorial shifts of resources and large scale programs of investment addressed to issues like modernization of agriculture, acceleration of industrialization and to more specific problems such as in the cases of the Austrian energy problem or the Polish railways, as seen next chapter50. By and large "sound finance" stood as an obstacle to that for it not only restricted these governments' role in the process but it also meant to maintain these economies in a chronically depressed state that was not conductive to private initiatives in this regard. This is most clearly noticed in Austria and Hungary, for example, for which the large stabilization loans they contracted have been expressly earmarked for budgetary purposes and only at a great difficulty some parts of the unused resources were spent in investment programs. Austrian historian Edward Marz reported that the League program in Austria, despite its financial success, left behind a "gravely disequilibrated economy" as it dealt only with what he termed "the surface problems of the Austrian economy" 51. Another account with a broader focus makes the same point about the overall character of financial reconstructions in Central Europe: "the financial reorganizations carried out in the mid 1920s could overcome economic confusion but were in themselves unable to solve the domestic problems of economic reconstruction or to create possibilities of home accumulation on a level required to achieve economic recovery" 52.

50 The point has also been made by I. Svennilson (1954) p. 46. 51 E. Marz (1948) p. 619. 52 I. Berend & G. Ránki (1974a) p. 222. Table 2-1 Capital Inflows and Indebtedness , 1923-1928 (percentage ratios)

Curr. acc. deficit/GDP Capital inflows/ Debt service/exports 1924-26 1927-28 1924-26 1927-28 1924-26 1927-28 Austriaa 8.4 6.1 45.6 34.3 9.5 4.8 Hungary 2.8b 7.7 12.7b 63.1 5.3b 16.3 Poland 0.5 4.8 17.9 30.1 4.9 13.6 Germany 2.6 4.9 22.3 35.2 9.1c 18.9

SOURCES and OBSERVATIONS: (a) Includes 1923: we take 1923 GDP as equal to the one for 1924. (b)There are no figures available for 1925. (c) Including reparations as "debt- servicing". Balance of payments figures from LN (1927) pp. 58-59, 141-151, (1928) pp. 180-190, (1930b) pp. 91-93,149-151, (1931) pp. 52-53, Bank of Poland (1930) pp. 95-96 and R. Nötel(1984) pp. 156,182. GDP figures from B. R. Mitchell (1978) pp. 409-412, A. Eckstein (1956) p. 14 and S. Andic & J. Veverka (1964) pp. 241-242.

One probable consequence of this excessive emphasis on finance would be to preserve a considerable degree of non-adjustment throughout the 1920s, at least to the extent that the Brussels-Genoa guidelines were strictly followed; some indications in this respect can be gathered from Table 2-1. The table distinguishes two periods, the first corresponding to the three (four) years following the stabilization and the later period coinciding with the last two years of the lending bonanza of the late 1920s. Figures for earlier years are generally not available. It is interesting to observe that all four countries were heavy borrowers, especially in the later period, as shown by the third and fourth columns in Table 2-1. The implied growth in indebtedness is responsible to a significant extent for the increase in current account deficits observed in the second period. The apparent exception is Austria, but this is due to a statistical problem. Capital inflows into Austria were predominantly of short-term nature so that they are hardly recorded in the balance of payments statistics; in general it is assumed that the large unaccounted inflows observed in these years roughly correspond to these inflows. By doing so we obtained capital inflows/exports ratios of the same order of magnitude of the other countries for the latter period, but for the earlier period we obtained a number that seems high. This is explained by the fact that our procedure implies in including returning "hot-money" movements that were excluded from the capital inflows considered for the other countries. In any event this statistical problem explains the apparent reduction in the debt- servicing ratio and on the current account deficit observed in the later period. Austria and Hungary are the countries for which the shortcomings of the reconstruction strategies we have been discussing should be the most relevant, for both stabilized under programs implemented by the League of Nations. Austria actually provides the best expression of the Brussels-Genoa principles and their implied consequences; she shows a large current account deficit for 1923-1926, amounting to 8.4% of GDP, that was basically sustained by capital inflows. Hungary and also Poland and Germany show a considerably smaller current account deficit; it should be observed that for these three countries, in contrast to Austria, some form of "adjustment" was accomplished during the inflation/stabilization period. The nature of such "adjustments" varied a lot. For Hungary "adjustment" was less related to the League program than to the authoritarian government that ruled during the 1920s. The latter would actually establish a contrast with Austria in at least two instances: first, the levels of unemployment in Hungary during 1924-1926 averaged 15.4% annually53 while in Austria the 1924-1926 average was 6.0%54; and second, while in Austria real wages remained at levels about 20% to 30% higher than the 1914 levels in 1924-1925, in Hungary real wages would be maintained at levels 20% to 30% below pre-war levels during 1924-192555. As late as 1929 real wages in Hungary barely recovered 85% of 1914 levels56. Hungary, therefore, managed to effect some "adjustment" mostly through unemployment and through forced reductions in workers target real wages. In the later period, as unemployment was reduced, real wages made some gains and indebtedness grew current account deficits increased very significantly. Adjustment in Poland and Germany followed courses somewhat different from the Brussels-Genoa benchmark, as we will see in some detail in Chapters 9 and 10. Poland's current account deficit was very small in 1924-1926; it was 1.8% and 2.9% of GDP in 1924 and 1925 respectively, and in 1926 it was turned into a surplus of 3.3% of GDP. Three basic factors explain that: first the Poles attitudes towards reconstruction and stabilization contrasted very sharply with the corresponding attitudes in Austria and

53 Computed from figures from J. Vagö (1925) p. 348 and LN (1926b) p. 50 under the assumption that union membership did not change during 1925 and 1926. 54 E. Wicker(1984) p. 14. 55 ILO (1926) pp. 41-43 and 90-92. Hungary. They strongly emphasized investment expenditure and structural adjustment in detriment of "sound finance", as a result of which some "true" adjustment, in the sense of closing the foreign exchange gap, would be achieved. Second, the annexation of the industrial district of Upper Silesia in 1922 would represent a major improvement on the country's payments position. These two factors, which we will examine in great detail in Chapter 9, would explain the small current account deficits observed in 1924 and 1925. Third, a major would play an important role in producing the current account surplus observed in 1926. The drastic changes in would determine a reduction in imports of nearly a half from 1925 to 1926. The recovery of the economy, the removal of trade restrictions and the increased indebtedness would determine a sharp increase in the current account deficit in the later period. Germany also shows relatively small current account deficits in the earlier period which is explained by two factors: one is the rescheduling of reparations payments determined by the Dawes Plan; payments in this account were reduced from around 75% of exports during 1921-1922 to 3.6% in 1924 and 10.9% in 1925-1928, as shown in Table 2-4 ahead. Yet even so current account deficits corresponded to 2.8% and 4.9% of GDP in 1924 and 1925 respectively. In 1924 the unemployment rate was 13.5% and in 1925 it was reduced to 6.7%; in 1926 a major recession increased unemployment to 18.0% and reduced the current account to a near balance. Like in Poland, this effort was dismissed afterwards as the abundance of foreign capital turned current account balance unnecessary. In his much heralded exchange with Keynes, Ohlin explicitly argued as regards Germany that these capital inflows not only blocked but reversed the balance of payments adjustments and consequent resource reallocation ordinarily required to effect the transfer of reparations57. The abundance of borrowing opportunities during the 1920s would represent a "permanent" improvement in these countries' balances of payments position that would

56 I. T. Berend & G. Ránki (1974b) p. 159. 57 Ohlin's argument was that capital inflows largely in excess of reparations payments reversed the transfer mechanism to the extent income effects as well as exchange appreciation would work towards a trade deficit, not a surplus. Furthermore it would not signal resources to migrate to sectors producing tradables. Strong capital inflows therefore "largely explain why Germany's productive resources have to such an extent been used for production of capital goods for the home market and have not increased the output and marketing of goods", B. Ohlin (1929) p. 172 passim. The same point can be easily made from Kindleberger's point turn much easier the reconciliation of the demands of the labor movement and the requirements of external balance. Borrowing would perform a key role in the Austrian and Hungarian stabilizations, though for the latter an important part of the adjustment was inflicted on workers by force. Borrowing would certainly be important for Germany and Poland yet both managed to accomplish considerable degrees of adjustment during the inflation/stabilization period. The reopening of international capital markets offered these countries the opportunity to smooth or to evade their more fundamental adjustment problems; in this connection the character of the problem of stabilization was changed for the short run problem of stopping inflation was dissociated from the fundamental imbalances that had created the inflationary problem. The problem of stabilization was turned into a struggle to gain access to international capital markets, or to swallow or compromise with the tough recipes of Brussels-Genoa. In any event, even if the conditionality problem was solved there remained the problem of how to address the fundamental imbalances these countries faced. This was actually the crucial issue as far as the outcome of the episode of international lending in the 1920s was concerned. The growth of external indebtedness could certainly play a meaningful role in the process of adjustment provided that the allocation of external resources was sympathetic with the needs of domestic resource reallocation determined by the adjustment problems at hand. It has been often observed that if international loans are to be repaid at all its resources have to be allocated to uses compatible with generating equivalent earnings in foreign currency or in tradable goods58. In the present case, international loans would have to meet not only these conditions, but they also would be required to do away with the "initial" current account imbalances existent at the onset of the lending episode. Whether undisturbed market forces would be able to observe this intertemporal budget constraint is very debatable from a theoretical standpoint59. The relevant issue for our

that capital inflows into Germany recycled reparations payments reducing the need for real adjustments. Cf. C. P. Kindleberger (1984) p. 303. 58 This point has been repeatedly made in several contexts. It was stressed during the 1930s as a rationale for the widespread defaults of these years, as in Royal Institute of International Affairs (1937) pp. 67-68 passim . It was also argued during the 1950s and 1960s when international lending was predominantly project lending under multilateral agencies or direct investments, by H. B. Chennery & A. M. Strout (1966) passim for example. And it was again brought by the recent literature bearing on the lending episode of the 1970s and reschedulings of the early 1980s, such as for example in J. Sachs & R. N. Cooper (1985). 59 It could be argued, for example that an autonomous capital inflows would force an appreciation of the exchanges, or an increased and worse terms of trade, and increased income so as to generate a purposes is to verify whether the allocation of external resources were compatible not only with repayment but with closing the "structural" trade deficits; this is often what is involved in the issue of whether external resources were put into "productive" uses. In general the attitude among commentators is to consider the notion of "productive" uses very broadly, but it is often very unclear what those "productive" uses should be. A detailed and authoritative British investigation of 1937, for example, presented the sweeping conclusion that "capital invested in Europe was very largely used for unproductive purposes, it resulted in a rise in the standard of living in the borrowing countries, but did not increase the efficiency of their export industries to an extent sufficient to enable most of them to meet the full service payments on their indebtedness" 60. Another more recent investigation with an essentially Eastern European focus offered very similar conclusions, arguing that only between 30% to 50% of the public foreign indebtedness employed in that area went to productive uses61. A more detailed account of Hungarian indebtedness reports that from the total amount of public and private loans of long term nature raised between 1924 and 1929 around 40% was directly related to interest and amortization of past debt, 15% was devoted to public health, education and building, 25% found use in consumption goods and only 15% would have been used for "productive" purposes62. As regards Germany, for example, the performance appeared to be similar: "much of the foreign investment in Germany between 1924 and 1930 was of an unproductive nature, and an even larger proportion was of a kind which added nothing to the available supplies of foreign exchange" 63. The much-blamed villains have been the loans to provinces and municipalities64, which together with the typically "unproductive" stabilization loans such trade deficit thus effecting the "transfer" of the external resources in terms of goods. This argument can be clearly associated with the earlier work on the transfer problem, as in F. Machlup (1976) pp. 396-432 for example, and it is very interesting to observe that such mechanism seems not compatible with the idea that autonomous capital inflows should correspond to discounted future trade surpluses, the basic assumption for repayable international loans. 60 Royal Institute of International Affairs (1937) p. 279. 61 V. N. Bandera (1964) p. 66. The author obtained these numbers by excluding from the total state debt the values correspondent to stabilization loans and war and relief debts, and including short term credits. According to this method it is estimated for example that around 90% of Hungarian state loans contracted after the war and about half of the Polish state loans would have been "productive", ibid. p. 67, what is a clearly an overly optimistic account. 62 I. T. Berend & G. Ránki (1979) p.134 and (1974a) p. 230. 63 Royal Institute of International Affairs (1937) p. 235 and also C. R. S. Harris (1935) pp. 4-5. 64 C. R. S. Harris (1935) p. 5. as the Dawes and the Young loans represented nearly half of all Germany's postwar indebtedness65. The failure of the experiment of international stabilization, and of the spurt of international lending it entailed, could be otherwise attested by the strains observed after 1929 and the defaults and moratoria that followed66. It is true that the collapses of the early 1930s might not be entirely attributed to ill directed lending, for lending could have been self-liquidating but in a longer horizon. But it seems out of question that lending was effectively misallocated and the prototypical stabilization policies greatly increased external vulnerability. In sum, the overemphasis on "sound finance", a laissez faire approach to the more fundamental problems faced by many European economies and ill directed lending ruined the experiment of international stabilization in the 1920s.

2.4) Contraponto: Stabilization loans after World War II

The comparison between the strategies of reconstruction and stabilization following the two World Wars is quite revealing especially if one notes that the outcomes - the Depression and the long prosperity of the 1950s and 1960s - differ very sharply. The list of contrasts between these two experiences is so very extensive and so very illuminating, and it is certainly worth exploring it at some length for the remainder of this chapter. The first observation about the aftermath of the Second World War, is that, much in contrast with the events after 1918, it was a planned outcome for which the concern about avoiding the mistakes of the 1920s played a major role67. Planning for the peace actually started as early back as in 1941 with the Atlantic Charter, and already in the spring of 1943 two comprehensive plans of international monetary stabilization, the Keynes and the White plans, had been given to public opinion. Both plans were highly innovative with respect to the practices of the 1920s, since both conceived an

65 Royal Institute of International Affairs (1937) p. 237. 66 Considering only the dollar issues of governments, provinces and cities in 1933 the total debt outstanding for Austria, Hungary and Germany summed to 53.4 million, 80.5 million and 524.4 million dollars respectively and the amounts of interest and sinking fund in arrears summed up to 4.8 million, 7.4 million and 16.7 million respectively. Poland did not have arrears at this point but would a little later in 1936. Cf. M. Winkler (1933) pp. 182-197. international mechanism to accommodate balance of payments difficulties, including provisions for international liquidity and rules for adjustment, which on one hand was independent from the private international banking establishment and on the other carried an explicit concern with the maintenance of high levels of employment68. Indeed, the attitudes and policy assumptions of those involved in postwar planning during the 1940s in both sides of the Atlantic contrasted very sharply with those of the 1920s. On the American side, for example, financial planning was mostly conducted by the Treasury Department under a distinguishing philosophy. Henry Morgenthau and Harry White, the dominant figures at the Treasury, "were not believers in laissez faire - as argued by a historian, they shared the beliefs of most New Deal planners that government had an important responsibility for the successful direction of economic life. To some extent they were under the influence of ... In their view the events of the 1920s and early 1930s had discredited private finance. They considered government control of financial policy the key to the objective of high employment and economic welfare"69. Apart from that the swing of public opinion had been remarkable. Though the old isolationism was still present it was much less influential as regards issues as the White plan, the British loan and the Marshall Plan than the opposition of the financial orthodoxy, notably from the New York financial community70. On the British side it is essential to observe that the dominant figure as regards international financial planning was perhaps the sharpest and most qualified critic of the attitudes and modes of thought of the 1920s, especially as regards the notion of the unrestricted sacrifice of domestic levels of employment on the altar of the gold standard. Apart from that had been responsible for a still ongoing revolution

67 R. N. Gardner (1969) pp. 4, 76 passim , E. F. Penrose(1953) p. 217 passim and J. H. Williams (1947). 68 The new institutions could obviously be managed according to "sound banking principles" and in this case we would not have much change with respect to the 1920s. Indeed, a few years later, the experience of stabilization programs under the Fund's supervision would clearly indicate that the passing of the keynesian momentum was quicker than one would expect. Already in the 1960s, and consistently later on, the Fund was prescribing good old sound orthodox programs all over the world. As regards the late 1940s however the distinguishing feature seemed to have been the attitudes of postwar planners. 69 R. N. Gardner (1969) p. 76. It is curious that while during the 1920s much attention had been given to the shift of financial leadership from London to New York, at this point Morgenthau aimed much higher, namely "to move the financial center of the world from London and Wall Street to the US Treasury and to create a new concept between nations in international finance", idem, ibid. See also F. L. Block (1977) pp. 38-40. 70 R. N. Gardner (1969) pp. 74, 129 passim and F. L. Block (1977) pp. 34, 52-54. See also C. S. Maier (1981) p. 341. in economic ideas, which had had a devastating effect over the standing of orthodox or "classical" economists71. As regards public opinion, the obstinate concern about full employment, about the ability to insulate from adverse developments abroad and the strong recriminations against the gold standard and its champions, all of which revealing the influence of Keynes in some degree, marked an extraordinary contrast with British attitudes during the 1920s72. It is true, however, that, according to a participant's account, "political expediency" resulted often more relevant than the advice of professional economists 73. But let us not forget, however, the maybe not yet classical remarks that "madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribber of a few years back" 74. This was extraordinarily true at this juncture, when the principal of these "voices" was not only still alive but very intensively participating in postwar planning. It is significant that both the Keynes and the White plans clearly distinguished a problem of monetary stabilization and a longer term problem of reconstruction and recovery75, which came to be later embodied in the division of labor between the Fund and the Bank, again in sharp contrast with the 1920s when the later problem if not wholly ignored was not properly considered. But on their way to compromise the plans merged into a much more conservative being the new institutions having their role considerably reduced during what was called the "transitional" phase, the period between the end of the "relief" phase and the moment in which a peacetime "equilibrium" would be restored76. These developments elicited thoughts that "the early promise of postwar planning was not fulfilled" 77, but the feeling would be short-lived, as an unprecedented program of stabilization, aid and investment, the Marshall Plan, would fill the gap. The contrasts between the Marshall Plan and the "uncoordinated and piecemeal" stabilizations of the 1920s start with the fact it was a coordinated effort, to the extent it joined 17 countries into one organization, the CEEC (Committee of European Economic

71 Such as, for example, his fellow Cambridge professor A. C. Pigou, a member of the Cunliffe Committee and of the group of experts reporting in the Brussels conference. 72 R. N. Gardner (1969) pp. 98, 122 passim. 73 Though professional economists "played an immensely greater role in the affairs of the state than ever before". Cf. E. F. Penrose (1953) p. 362. 74 J. M. Keynes (1936) p. 383. 75 R. N. Gardner (1969) p. 75 and E. F. Penrose (1953) p. 348. 76 F. L. Block (1977) pp. 47-55, R. N. Gardner (1969) p. and E. F. Penrose (1953) pp. 181-182, 352. Cooperation, later the OECD), which in view of specific needs and problems of each member country and the overall compatibility of these demands and projects, presented a consolidated program to the US government calling for some US$ 29.2 billion in four years as aid and proposing the allocation of such funds 78. The Plan's priorities contemplated principally an effort to restore quickly pre-war levels of production and growth and an attempt to solve Europe's dramatic dollar deficit, primarily through the expansion of exports. In addition to that the Plan also sought to foster economic cooperation and integration in Europe and the "creation and maintenance of financial stability" 79. Most essentially however the Plan's conception revealed a gigantic adjustment program whose most distinguishing feature was that it was "primarily a program of investment" 80. The allocation of funds should obey a strict "project procedure" oriented towards the investment projects proposed by the individual countries through the CEEC, and most significantly the Plan's administrators explicitly stated the "local currency counterpart releases for investment were to be maximized; for general financial purposes, minimized" 81, an astonishing contrast keenly noted by Austrian historian Edward Marz82, with the stabilization plans of the 1920s. There has been strict conditionality but little tension as regards the allocation of funds, as after all the projects had been proposed by the European themselves; the only point of friction was related to commercial policy and European integration 83. Some more noticeable tensions had arisen between the plan's priorities on industrial investment and the need to maintain inflations under control, but though inflation had been high in some countries it resulted not to be a major concern at least until the start of the Korean war84. Even in the presence of inflation, "sound finance" has not been a priority, not only

77 E. F. Penrose (1953) p. 357. 78 As an illustration it is interesting to note that total governmental loans outstanding in 1946 summed US$ 14.5 billion including the British Loan of US$ 3.7 billion, Eximbank loans, lend-lease credits and many other types of loans. The US alone was responsible for approximately US$ 9.0 billion, the rest being provided mostly by Canada, UK, Sweden, Argentina and Switzerland. It is revealing that the corresponding total for intergovernmental loans in 1919-1920, when the was nearly the same as of 1946, was of only US$ 3.8 billion, cf. M. A. Kriz (1947) pp. 2, 13, though it should be observed that the level of world trade in 1946 was some 40% greater than its 1919-1920 levels. 79 H. B. Price (1955) p. 37. 80 Ibid. p. 116. 81 Ibid. pp. 116, 316 passim. 82 E. Marz (1982) p. 190 . This was also observed by G. Harberler (1982) p. 62. 83 H. B. Price (1955) p. 315. 84 Ibid. pp. 152-154. in view of the fact that the Plan's administrators believed that inflation could be kept under control by a "high degree of planning of investment decisions85, but also in view of the Keynesianism of the times, the concern about full employment and some skepticism about the old recipes. Quite significantly finance was hardly a theme in these years while it was the issue during the 1920s. A further contrast to be mentioned is the handling of the reparations issue. The experience of the 1920s loomed large and was certainly a moderating influence; yet problems in this regard would be created by the Soviets, whose demands on account of reparations were described as "more curbed than those advanced by the Versailles victors under less aggravating circumstances" 86. The East-West antagonism would play a major role in this issue for it led the Allies towards a strategy of reviving Germany, instead of a proposed "pastoralization", and it would also produce moderation as regards reparations. Germany would eventually pay yearly sums that averaged 0.72% of national income and 3.1% of exports during 1953-1965; Japan and Italy would be assigned similar burdens 87. These payments represented very light burdens to these countries especially if compared with the sums paid in the 1920s. It was even argued that these reparations payments have had a positive impact to the international economy for the recipients were small or underdeveloped countries for which these payments were very significant. During 1953- 1965, for example, German reparations payments to Israel represented an annual average of 12.8% of Israeli national income (27.1% of imports). Italian reparations represented between 0.4% and 2.6% of national income (1.4% to 7.5% of imports) every year for Ethiopia , Greece and Yugoslavia and Japanese payments contributed with 0.1% and 1.3% of national income (0.6% to 7.8% of imports) for seven Asian countries88

2.5) Conclusions

This chapter aimed at providing the historical context within which the stabilizations of the 1920s should be seen. In this respect we discussed the assumptions

85 F. L. Block (1977) p. 91. 86 M. Gottlieb (1950) p. 26. 87 B. J. Cohen (1967) pp. 285-287. 88 Ibid. p. 288. and attitudes held by the authorities of the time and their evolution from the concepts developed in connection with the pre-war gold standard. The dominating attitude towards these problems in the core economies was essentially a laissez faire one: it seemed that by maintaining finances on a "sound basis" the imbalances to be found especially in the “new” countries of Central Europe would eventually be resolved. Yet, foreign capital should have to play a key role in this respect for it would have to be put to uses not only compatible with its own repayment but also to remedy the original imbalances. The whole experience with international lending in the 1920s seems to indicate that nothing of this sort effectively took place. The outcome of this lending episode was disastrous and this further reinforces the contrast we discussed between reconstruction in the 1920s and following the World War II.

Chapter 3

Adjustment issues in hyperinflations countries 3.1) Introduction

Last chapter mentioned in various instances the presence of serious adjustment problems in some European countries, notably the ones whose frontiers were subject to very significant changes by the Peace Treaties and also to the payment of reparations. The purpose of this chapter is to describe such problems and to assess their magnitude and likely contribution to the hyperinflation process. It is important to dissociate the chaotic conditions prevailing in Central Europe immediately after the war from the problems of a more "structural" nature generated by the new frontiers established for the Successor States and by the payment of reparations imposed to Germany. Austria and Hungary lost about 2/3 of their territories and populations and the new Poland was reunified after more than a century foreign domination. It is argued at length in Section 3.2 that the adaptation to these new realities represented a major adjustment problem and that would have to be undertaken under very unfavorable conditions. For Germany the external "imbalance" in the early 1920s was less connected to territorial changes and war dislocations than to the payment of reparations. Section 3.3 discusses at some length the old issue of the burdens of reparations, but notes in this connection that the "transfer problem" faced by Germany, and also by the Successor States, would be made much harder by one very important domestic factor, namely the very strong pressures to increase real wages that stemmed from the extremely low level at which they were and from the extraordinary strengthening of the labor movement observed after the war. Indeed, as argued in Section 3.4, the early 1920s would bring very significant social transformations with sweeping consequences as regards labor markets in Europe. Astonishing increases in unionization, the adoption of compulsory collective agreements and the strength of socialist parties would determine nearly irresistible pressures to recompose pre-war levels of real wages. Section 3.4 also presents figures for real wages immediately after the war highlighting the extraordinarily low level to which wages had fallen in the hyperinflation countries. This fact by itself would mean to impose strict limits to possible reductions in the "standard of living" necessary for adjustment reasons. This "inconsistency" between politically acceptable levels of real wages and external balance provides a promising explanation for the hyperinflations in these countries, to be explored in detail in Chapter 4 ahead. The reconciliation of these demands with the adjustment problems should be one of the key factors for the stabilizations, as we will observe in Chapter 8, 9 and 10.

3.2) Adjustment Problems in the Successor States

3.2.1) The new frontiers The redrawing of Central Europe's political and economic map determined by the Peace Treaties has been termed "the biggest exercise in the reshaping of the political geography of Europe ever undertaken" 1. Entirely new countries were created while the remaining others had their area and population greatly modified. The most important changes have been the dismemberment of the Austro-Hungarian Empire into three new countries and the reunification of Poland after 125 years during which she was partitioned between Germany, Russia and the Austro-Hungarian Empire; this is pictured in Table 3-1.

Table 3-1 Successor States: Area, Population and National Income, 1913-1921

Areaa Populationb National incomec Country 1913 1921 1913 1921 1911-13 d d e Austro-Hungarian Empire 676.4 - 51.4 - 100.0 Austria - 85.5 - 6.5 29.7 Hungary 325.0 f 92.6 20.9f 7.6 - Czechoslovakia - 140.4 - 13.6 44.7 Bulgaria 111.8 103.1 4.7 4.9 - Rumania 137.9 304.2 7.5 17.6 1.7 f Serbia 87.3 - 4.5 - - Yugoslavia - 249.0 - 12.0 3.6 Poland - 388.3 - 27.2 15.1 SOURCES and OBSERVATIONS: (a) Area in thousands square kilometers, not including minor additions to Italy and Greece and from Germany and Russia. (b) Population in millions. (c) National incomes as percentages of the average for 1911-13 national income of the Austrian half of the Empire. (d) Including Bosnia-Herzegovina. (e) Include 5.2% corresponding to territory given to Italy. (f) The Hungarian Kingdom of the Austro-Hungarian Empire. From I. Berend & G. Ránki (1974a) p. 173 and (1979) p. 111 and A. Teichova (1983) p. 532.

1 D. H. Aldroft (1981) p. 22. These extensive territorial changes would create formidable adjustment problems: the new frontiers cut across "natural" economic cleavages, obeying an "uneven mixture" of political, military, "historical" and economic considerations2, turning much harder the already complex problem of splitting of a that endured for half a century and within which a specific pattern of division of labor had been long established3. Besides, the conditions under which these adjustments would be made were by no means favorable. Comparing Austria to other European small open economies such as Switzerland, and Denmark for example, Edward Marz observed that these countries "had been fitted into the larger framework of the European economy over a long period of time, and in the extremely propitious climate of 19th century liberalism, whereas Austria was faced with the task of a speedy readjustment in the frigid trade climate of the 1920s"4. On the domestic side two important disturbing factors should be mentioned: (i) the incredibly low level of real wages observed after the war, and the labor movement's strength and the pressure it exercised towards recovering pre-war values, reduced the scope for gains in competitiveness from the compression of real wages and turned unemployment a less feasible alternative. (ii) Adjustment required modernization, technological update and scale adjustment in many sectors of these countries' economies- like in the Austrian metal, mining and energy industries or in the Polish railways, for example - which basically required thorough investment programs, which often implied in pressures over public expenditure5. Inflation was an immediate consequence of the impasse between the needs of adjustment and the pressures to increase real wages and over budget deficits. Another consequence of these tensions was to generate claims for -

2 J. Bloomfield (1985) p. 233; L. L. Ecker-Rácz (1933a) p. 71 and D. H. Aldroft (1981) p. 27. 3 There were several instances of division of labor within the Empire, the most noteworthy being the concentration of agriculture, especially cereal production, in the Hungarian half, the location of banking, finance and trade connections in Vienna and the development of industry in the later Czech lands. A especially interesting example is provided by the textiles industry where spinning and finishing were predominantly Austrian whereas weaving was the specialty of the Czech lands. Similar patterns could also be found in chemical, ironworks and wool industries. Cf. J. Bloomfield (1984) p. 234 and E. Marz (1948) p. 262. Regarding the Polish lands, the Habsburg rulers had a clear purpose of maintaining Austrian Poland essentially agricultural as to serve as a granary for the rest of the empire. Cf. J. Taylor (1953) pp. 10-11. On the formation and development of the Habsburg customs union see J. M. Komlos (1983). 4 E. Marz (1948) p. 302. often under the cover of nationalist struggles - actually drifting these countries into very restrictive commercial policies and determined efforts to stimulate import substitution6. These policies represented a further blow to these countries' trade prospects. The intra- Danubean trade suffered a marked shrinkage during the 1920s: considering only the mutual trade of Austria, Hungary and Czechoslovakia, its share over the total trade of these countries declined from 33.8% in 1921 to 22.3% in 1928 for Hungary, from 30.1% in 1922 to 24.6% in 1928 for Austria and from 26.6% in 1922 to 17.0% in 1928 for Czechoslovakia7. This shrinkage is partly due to restrictive trade policy, but it is also an indication of the presence of effects in the Austro-Hungarian-Czech customs union. It is interesting in this regard to observe the degrees of openness reported in Table 3-2. Pre-war Central Europe was dominated by two large empires markedly hostile to each other and autarkic in nature. Indeed, as shown in Table 3-2, the Austro-Hungarian and the Russian Empires showed the lowest degrees of openness in 1913. The Successor States became much more open economies during the 1920s than the Habsburg Empire was in 1913, as seen in Table 3-2; this was partly to be expected for some of what was "domestic" trade was turned "international". Poland was an exception in this regard. Over the years Polish lands developed strong economic connections with the respective partitioning empires in detriment of the economic intercourse between the Polish territories: it has been estimated that in 1913 only 7.4% of the total trade of these Polish provinces took place among themselves while 84.5% was with the partitioning powers and 8.1% with other countries8. Yet, in the early 1920s these trade channels would be drastically shrunk, notably by the closure of Russia, the successive tariff wars with

5 For details see E. Marz (1948) pp. 302-304 passim. For details see E. Marz (1948) pp. 302-304 passim. 6 I. Berend & G. Ránki (1974a) , F. Hertz(1947) and L. Pasvolski (1928). 7 Cf. L. Pasvolski (1928) pp. 147, 338-339, J. Bloomfield (1984) p. 264 and F. Hertz (1947) p. 80. In 1922 51.3% of Austrian exports were destined to the Central Europe excluding Germany, which was reduced to 40.1% in 1928 and further to 34.3% in 1935. The corresponding numbers for Hungary were 76.9%, 68.4% and 31.6%, and for Czechoslovakia were 41.3%, 34.4% and 25.2%. Cf. F. Hertz (1947) p. 82. 8 An interesting example is provided by the textiles industry of Lodz, in the former Russian partition, responsible for a large portion of the total textiles output in the new Poland. All of the exports of textiles from these lands had Russia as its destiny while 82.6% of the imports of textiles, composed primarily of raw materials, also came from Russia. Cf. Z. Landau & J. Tomaszewski (1985) p.13. It should be observed that the textiles industry was the largest of the new Poland according to the number of workers employed. Germany9, the strict commercial policies in the Danubean area and by no means the least of it the strong sentiment for self-sufficiency in Poland.

Table 3-2 Ratios of Foreign Trade to National Income: 1913-1929 (exports plus imports divided by two over GNP) country 1913 1920-23a 1924-27a 1929 Austro-Hungarian Empire 13.8 - - - Austria - n.a. 24.3 22.6 Hungary - 18.5b 16.3c 16.1 Poland - n.a 13.1 11.4 Czechoslovakia - 30.2 27.2 27.3 Germany 20.8 n.a. 16.1d 18.0 France 21.3 - - 23.2 United Kingdom 29.6 18.1e 21.5d 24.6f Russia 6.8 n.a. n.a. n.a. Denmark 32.2 26.3g 34.5d 33.7f Belgium 66.1 50.5h 57.9i 43.2j Switzerland 41.7 31.1h n.a. 25.1f SOURCES and OBSERVATIONS: Some ratios from K. W. Deutsch & A. Eckstein(1961) and others computed from national income and foreign trade on B. R. Mitchell(1978). The ratio for the Austro-Hungarian Empire considers national income of Austrian half from A. Teichova (1983) p. 532 and of the Hungarian half from F. Fellner(1930) p. 81 and A. Eckstein (1956) p. 14. Polish rations from national income estimates in Z. Landau (1976). (a) yearly averages. (b) 1921 only. (c) 1925-1927. (d) 1925 only. (e) 1922 only. (f) 1928 only. (g) 1920 only. (h) 1924 only. (i) 1927 only. (j) 1930.

The extent of or trade diversion generated by the new frontiers can be assessed by deducting from the ratios reported in Table 3-2 the share of the mutual trade among Austria, Hungary and Czechoslovakia and compare this "corrected" degree of openness with the value of 13.8% for the whole empire in 191310. Hence computing these "corrected" ratios for Austria and Czechoslovakia we obtained values of 19.8% for the former in 1925 and 26.2% for the latter in 1922 11, indicating that these countries enjoyed substantial trade creation effects with the new frontiers. The same would not be true for Hungary whose degree of openness deducting the shares corresponding to

9 C. Kruszewski (1943). 10 The procedure would not be rigorously correct, first because the Habsburg Empire included more territory than these three countries together, as it is easily seen in Table 3-2. From the methodological point of view one problem is that the procedure does not control for other factors, such as for example commercial policy, which certainly has had a trade diverting influence. 11 For Austria we deducted from openness in 1925 reported in Table 3-2 the joint share over total trade of the trade with Hungary, Czechoslovakia and Poland, which summed to 37.0% in 1925. Thus multiplying 24% by (1-0.185) we obtained 19.8%. For Czechoslovakia we deducted from total trade the share of Austria, Hungary, Yugoslavia and Romania, which summed up to 26.6% in 1922. Thus multiplying 30.2 by Austrian and Czech trade would be of only 12.2% in 192112. This would seem to point out cœteris paribus that the customs union has had a slight trade creation effect13, but most likely such decreased "corrected" openness, despite the continuously falling share of the trade with Austria and Czechoslovakia, is compatible with the conscious effort by the Hungarian authorities to promote industrialization by import substitution14.

3.2.2) Czechoslovakia

It should be observed that the capacity to undertake the adjustments required to these new conditions, and in particular the export possibilities, were very unevenly distributed among the Successor States as the Peace Treaties had assigned to Czechoslovakia a "disproportionally large share of the former Monarchy's economic potential" 15. Indeed Czechoslovakia starts showing strong and consistent trade surpluses as early back as in 1920, in sharp contrast with Austria and Hungary for which exports represented respectively 54.8% and 39.3% of imports in this year 16 and also, with Poland17. It is interesting to observe in this connection that the Habsburg monarchy as a whole had been a debtor economy before the war, a chronic trade deficit being financed to a substantial extent by incomes from services, such as transit traffic, banking and trade commissions, tourism, emigrant remittances and by new borrowing18. After the war the

(1-0.13305) we got 26.2%. The figures are from J. Bloomfield (1984) p. 264 and L. Pasvolski (1928) p. 147. 12 The share of the Hungarian trade with Austria and Czechoslovakia over the total was 33.8% in 1921, so that multiplying 18.5 by (1-0.338) we obtained 12.2%. Figures are from L. Pasvolski (1928) pp. 338-339. 13 Which would seem paradoxical in view of the complaints that existed in the Hungarian Kingdom about its position within the union, which stemmed, to some extent, from the kingdom's interest in fostering industrialization. Cf. E. Marz (1948) p. 139-145 and L. L. Ecker-Rácz (1933a) pp. 5-10 passim. 14 F. Hertz (1947) pp.70-71. 15 Around 70% of the industrial capacity of the Empire Western Provinces was given to Czechoslovakia: she retained over 50% of all factories of the Austrian half of the Empire (while Austria got 32.4%), 63.8% of all boiler surfaces (against 18.3% given to Austria), 75% of the coal mining, 60% of the iron and metal industries, 75% of chemical works, 75% to 80% of the textile and building material industries, 92% of the sugar production and nearly 100% of glassware industries. Cf. I. Berend & G. Ránki (1974a) p. 182 and E. Marz (1948) p.136 and 249. 16 J. Bloomfield (1984) p. 252 and L. Pasvolski (1928) p. 329. 17 See J. P. Young (1925) vol. II p. 354. 18 According to L. Pasvolski (1928), during the period 1909-1913 the Empire's accumulated trade deficit was of 2,400 million crowns and net interest payments summed to 1,550 million crowns, while emigrant remittances totaled 1,500 million crowns, commissions and traffic yielded 700 million crowns and tourism another 500 million crowns. Cf. p.10-13. See also W. T. Layton & C. Rist (1925) pp.124-125. main sources of credit, France and Germany, were no longer available, in view of their own financial problems, and the British and the US appeared little interested in performing this role 19. Vienna lost in part its position of trading intermediary and banking agent between Western and Eastern Europe and consequently the income derived from these functions20; furthermore the best part of the former Monarchy export potential was given to Czechoslovakia, which had the consequence of leaving a magnified import surplus to the other Successor States. Apart from that, to the extent the Czechs stood on the winning side of the war they assured themselves not only the freedom to levy tariffs and the allies goodwill regarding MFN agreements and commercial credits but also the privilege of collecting reparations, or at least of not paying any21. Czechoslovakia held actually a very small share of the reparation liabilities of Hungary and Bulgaria, but this is certainly better than to own reparations, as Austria and Hungary. It had become clear quite early that the scope for collecting reparations from Austria and Hungary was very reduced, but its mere presence, and especially the first lien it held on Austrian and Hungarian state property, precluded the access to international credits in addition to creating an unfavorable atmosphere for a stabilization effort22. The list of contrasts favoring the Czech Republic could be considerably multiplied, as explored by comparative studies such as J. Bloomfield (1984) and A. Teichova (1984). It should be noted that according to Sargent's account of the European hyperinflation Czechoslovakia did not plunge into hyperinflation by virtue of a

19 I. Berend & G. Ránki (1974a) p. 223. 20 For which it was also important the disturbed trade conditions of the early 1920s and the other Successor States policies of developing their own trade and financial connections. See E. Marz (1948) p. 519. 21 Both made some deliveries in kind immediately following the war, but not in very significant amounts. To Austria for example, was never imposed a schedule of payments and in 1930 the Austrian liabilities were written off by the Hague agreements on non-German settlements. Hungary received a quite different treatment. A provisional schedule of payments was established in 1924 and it was made definitive by the Hague agreements. The total payments summed to around 50 million dollars mostly due to Greece and Romania, but up to 1926 payments were effected mostly in the form of coal deliveries to Yugoslavia. Cf. H. G. Moulton & L. Pasvolski (1932) pp. 234-246 and I. Berend & G. Ránki (1974a) pp.184-185. 22 Reconstruction was "not burdened but ...hindered by reparations [w]hich... hung like a sword of Damocles over the economy of the defeated countries, threatening the balance of the state finances and the budget, imposing to some degree psychological impediments to economic reconstruction, affecting the accumulation of capital and preventing productive investments ... it kept the countries of East-Central Europe in perpetual uncertainty, served as a pretext for kindling a chauvinistic-revanchist atmosphere, and became one of the handicaps to the economic development in that area". Cf. I. Berend & G. Ránki (1974a) p.185. purposeful policy choice towards fiscal austerity23. Although this could be held to some extent as one of the contrasts, the most important point is probably that the superior strength of the Czech's economy allowed policy choices that were not feasible to other countries.

3.2.3) Austria At the immediate aftermath of the war the Austrian situation appeared especially serious. The new Austria inherited an "extremely acute problem as regards fuel", as it had almost no coal deposits within its frontiers, and a no less dramatic food problem 24. Both problems were made very difficult in the early 1920s in view of Austria's inability to supply herself in the disrupted international markets25; these, however, were problems of a longer run nature that would make themselves felt for the whole decade. Austria's energy problem was described as her "Achilles heel", as the country faced the dilemma of relying on its exports to buy coal in international markets or to develop a more intensive use of her lignite deposits and her hitherto unexplored hydroelectric potential 26. The food problem had had its origin in the previous dependence on Hungarian cereal surpluses and in the inherent weaknesses of Austrian agriculture with its insufficient acreage and low productivity. The development of domestic output faced problems of topographic nature, suffered from capital and labor and was hampered by the belated survival of feudal institutions in the form of commons and small plots27. In addition to that Austrian industry was handicapped by the poor raw materials endowment given by the new frontiers, some sectors such as those producing luxuries had little prospects of recovery while others were tailored for a closed market of 50 million people, the result of these being the chronic unemployment and idle capacity experienced by industry during the 1920s 28. Vienna's size was regarded as a serious issue

23 T. Sargent (1982) p. 85. 24 J. Bloomfield (1985) p. 234 and E. Marz (1948) pp. 278-280, 288. 25 Both problems were strongly felt in Vienna in the immediate post-war, the shortages experienced being second only to those of Russia. Cf. LN (1926a) p. 10. By virtue of this the Austrian conditions have been described with adjectives such as "disastrous", "catastrophic", "tragic" and "chaotic". See I. Berend & G. Ránki (1974a) p. 174, J. Bloomfield (1984) pp. 236-240, L. Pasvolski (1928) p. 95 and K. W. Rothschild (1947) p. 19. 26 E. Marz (1948) pp. 288-293. 27 Ibid. pp. 275-284. 28 Ibid. pp.293, 299 and 632-633. as it stood allegedly out of proportion with the country's economic possibilities 29. These problems weighted heavily and directly not only upon the new republic's balance of payments but also upon the budget, especially in the form of doles and food subsidies. In addition to that the first budgets of Austria were further burdened by the massive return to Vienna of government officials in numbers that had been considered excessive for the administration of a country of 30 million people 30. The dimension of these problems, or at least their appearance, was such that the issue of the economic viability of the new country was very seriously raised; "the widespread conviction, according to a historian, [w]as that the remnant of the old Austrian Empire which was to constitute the new Austria was incapable of independent existence" 31. This alleged "non- viability" was especially emphasized by the Socialist Party which had as part of its program the Anschluss and continuously campaigned over what was called the Austrian Dilemma: the union with Germany or non-existence. In 1919, under their influence, the Provisional National Assembly had even passed a declaration favoring the Auschluss 32.

3.2.4) Hungary Hungary's post-war economic prospects seemed better than Austrian's at least to the extent that her being a predominantly agricultural country the aftermath of the war did not bring the "prospect of imminent starvation" it did in Austria33. But, on the other hand, Hungary experienced some very serious political convulsions up to 1921. A short lived Bolshevik revolution, a Romanian invasion, a civil war and two restoration attempts may possibly have done more damage to the country than the war itself34. Unlike Austria Hungary's attitude towards her neighbors was essentially hostile in consequence of which the issue of the viability of the new Hungary was appraised very differently with respect to the corresponding Austrian problem: while the existence of a healthy Austria was regarded as necessary for balance of power reasons, the existence of an Hungarian state

29 Ibid. pp. 269-273 and K. W. Rothschild(1947) p.19. 30 L. Pasvolski (1928) p.104-105. 31 Ibid. p.108. K. W. Rothschild (1947) p. 19-20, adds that, "the general attitude of the leading politicians ... was to profess complete disbelief in Austria's ability to exist as an independent entity". Austrian historian Edward Marz's verdict on the issue was "pessimistic". Cf. E. Marz(1948) p. 317. 32 Ibid. p.237 and J. Bloomfield (1984) p. 232-233. 33 LN (1926a) p. 10, L. L. Ecker-Rácz (1933a) p. 132 and LN (1926b) p. 9. 34 L. Pasvolsky (1928) pp. 291-292. seemed to represent on the contrary a threat to peace in the region35. In this connection one understands the quite different treatment given to Austria and Hungary with respect to the reparations issue. A schedule of payments was never imposed to Austria, and in 1930 the liability was written off by the Hague agreements on non-German settlements. Hungary, in contrast, had her payments schedule established in 1924 and confirmed by the Hague agreements. The total liability was small - 50 million dollars - and smoothly made in the form of coal deliveries to Yugoslavia, but the tensions it created were certainly significant36. Hungarian agricultural output had fallen to around one third of its pre-war volume in 1919. At this point, however, with the closure of the Danubean markets, a recovery of output required that the surpluses be produced at prices competitive in world markets, and this represented no easy adjustment to Hungarian agriculture. After 50 years of production for a protected market of 50 million people Hungarian agriculture "lost all contact with international developments ... [a]nd had fallen into a state of invalidism" 37. The necessary process of modernization would have to be superimposed on a backwards agrarian structure with lively feudal elements where strong interest groups systematically objected to attempts of land reform 38. These difficulties were considerably increased by the depressed trade conditions and weak terms of trade faced by Hungary in the early 1920s, so that in 1920 agricultural exports reached only 21% of it its pre-war values39.

3.2.5) Poland The new Poland inherited a number of difficult problems related to the lack of economic unity between the several regions of the country. The Polish lands have been kept isolated from each other and during the pre-1914 period no attention whatsoever was given to the economic development of these regions "as an organic whole": the partitioning empires took a very negative attitude towards the economic development of the Polish territories, which was "twisted, distorted and retarded to suit the conveniences

35 I. Berend & G. Ránki (1974a) pp. 214-215 and LN (1945) p. 39. 36 H. G. Moulton & L. Pasvolski (1932) pp. 234-246 and I. Berend & G. Ránki (1974a) pp. 184-185. 37 L. L. Ecker-Rácz (1933a) p. 3. 38 I. Berend & G. Ránki (1974a) pp. 191-192. 39 Ibid. p. 178. of the partitioning powers" 40. A simple and illustrative example of a serious problem in this regard was related to transportation. Three different railway networks had been established in the Polish territories according to the specific policies and needs of the partitioning powers, and consequently largely inappropriate for the needs of the new country. The normalization of economic life in Poland required a large-scale program of investments in reorganization, amalgamation, redesigning and also reconstruction of her railways 41. War devastations and pillages had been especially severe in the Polish lands, as hostilities lasted as late as 1920 at the Eastern front 42, and hit especially hard Polish railways as much of her rolling stock was either destroyed or carried away 43. In addition to that, Poland experienced an acute of coal, which further worsened the railway problem, besides being aggravated by the transportations deficiency, as the existing stocks could not reach the industrial districts44. Industry suffered heavily from the transportation and raw materials bottlenecks: with respect to the 1913 levels of employment, at the end of 1919 the metal industry was of only 12%, the textiles and paper industry stood at 25%, chemicals and food industries reached 35% and only the mining industry managed to recover most its pre-war levels of employment45. The situation of agriculture was also very serious as war devastations reduced markedly the area under cultivation and livestock 46, the levels of production of 1909-1913 being regained only by 1924-1928, though without any gain in yields per hectare 47. Polish agrarian structure was essentially backwards, especially in the Russian and Austrian partitions, and the new country faced a serious problem of rural overpopulation. With stricter policies from the immigrant receiving countries in the 1920s, the alternatives for

40 J. Taylor (1953) p. 3. 41 A. B. Barber (1923) passim. 42 The war against Soviet Russia over the drawing of the eastern frontiers ended only in March of 1920 with the Peace of Riga. On war damages see Z. Landau (1968). 43 It is estimated that one half of all bridges, stations and workshops were also destroyed. Cf. I. Berend & G. Ránki (1974a) p.176, A. B. Barber (1923) and Z. Landau (1968) passim. 44 A. B. Barber (1923) p. 63. Before the war the total consumption of coal within the Polish territories, apart from Upper Silesia, was of around 18.6 million tons per year, half of it imported. In 1919 Polish production reached only 6.2 million tons while imports have barely reached 950 thousand tons, forming then only 38% of the pre-war consumption. In 1921 production was increased to 7.6 million tons and imports reached 2.9 million tons performing 57% of pre-war consumption.. 45 Z. Landau (1968) p. 247. 46 I. Berend & G. Ránki (1974a) p.176. 47 Z. Landau (1969) pp. 83-84. absorbing this surplus labor, estimated to reach 11.5 million in 1930 48, have been fostering industrialization and the modernization of agriculture, which also required a program of agrarian reform, meaning parceling of latifundia and amalgamation of small plots and commons49. Both courses required large-scale efforts of investment, in addition to the political conditions, especially as regards agrarian reform, that were lacking during the immediate post-war years. Government finances were subject to several pressures. On the revenue side it should be observed that the three areas forming the new Poland were subject to different tax systems, whose unification and reform turned out to be very complex, being finally achieved only by 192550. Tax evasion had been continuously stimulated for many years as something of a patriotic practice: according to an observer, "for four generations [t]he Polish citizens rightly looked upon the tax collector as an agent of an alien and a hated domination, whom it was a patriotic duty to thwart” 51. On the expenditure side, an entirely new government administrative machinery had to be created, while the country was fighting a war that lasted until mid 1920, and labor unrest combined with the socialists' influence forced the introduction of a vast body of social legislation, which resulted very heavy for the first budgets of the new republic. In addition, a substantial part of the reconstruction outlays in domestic currency, especially those related to the railway problem, weighted upon the government budget.

To sum up, it appears an understatement to argue that the Successor States faced very serious economic problems at the end of the war. Their conditions immediately after independence, overwhelmed by famines, wars and revolutions, could be described, without any trace of exaggeration, as chaotic. Yet, it is important to observe that although inflations had started at this moment the switch to hyperinflation would come only much later, after economic conditions having been largely “normalized” or rid from the most direct effects of wars and revolutions. The earliest hyperinflation, according to Cagan's

48 According to a League of Nations study of 1946 quoted by J. Taylor (1953) pp. 76-77, assuming levels of productivity similar to the French then 11.5 million could leave the country without depressing the levels of production. 49 J. Taylor (1953) pp. 76-77. 50 F. Zweig (1944) p. 30. 51 E. H. Young (1924) p. 5. See also F. Zweig (1944) p. 17. definition, would happen in Austria in October of 1921, while the latest would be observed in Hungary in March of 1923 52. This is a powerful indication that the post-war inflationary process would be less connected to the initial chaos than to the more fundamental imbalances and adjustment problems that we described in this section.

3.3) Germany: the burden of reparations

The economic conditions of Germany after the war contrasted favorably with those of the Successor States: there had been no devastations or political disruptions of comparable magnitudes and the financial situation of the Reich, though certainly not comfortable, did not fare much worse than those of France and Italy 53. Like the Successor States a substantial part, most likely the greatest part, of German problems during the 1920s would be generated not by the war but by the Peace Treaties. Territorial losses, for example, though not as nearly comparable to those imposed to Austria and Hungary, had important consequences especially as regards German coal supplies, actually turning the country from a coal-exporting into a coal-importing country 54. The Treaties also determined the surrender of nearly all of Germany's merchant fleet and all of her foreign investments; these provisions would result troublesome to the German balance of payments. Incomes from such "invisibles" - notably shipping earnings and returns from foreign investments - financed a chronic trade deficit, averaging 17.5% of imports during 1909-1913, and even allowing for a steady flux of capital exports of long term account of around 400 million gold marks yearly55. In these circumstances, the loss of earnings from invisibles, the normal war dislocations affecting export industries, the high import requirements determined by reconversion and restocking and the coal problem would compose a picture of a serious, though a hardly overwhelming, balance of

52 Cagan's defines the start of an hyperinflation as the month in which in which inflation was greater than 50%, P. Cagan (1956) pp. 25-26. 53 C. P. Kindleberger (1984) pp. 295-296. 54 Especially after the League of Nations arbitration on the Upper Silesian question in 1921, ceding these territories to Poland. Cf. J. M Keynes (1920) pp. 81-97 and (1922) pp. 32-33 passim and Republic of Germany-Krieglastenkommission(1924) p. 38. As argued below this territorial change would represent a major improvement for the Polish balance of payments with important implications as to her adjustment problems. 55 H. G. Moulton & C.E. McGuire (1923) pp. 23-33 and appendix A pp. 251-295, and Republic of Germany (1923) pp. 21-22. payments adjustment problem. On the fiscal side the situation was no better, the main pressures being the commitments under the Versailles Treaty and the domestic debt. The impact of reparations payments would be more clear after the London Ultimatum in 1921 when cash payments started. In the fiscal year of 1922, for instance, reparations payments totaled 3,600 million gold marks, while total tax revenues reached 3,580 million, the remaining expenditures summing 6,265 million and accounting for nearly all of the increase in the floating debt within this period namely 6,384 million gold marks56. The real value of the domestic debt reached a maximum in the end of 1918 when it was 58.5 billion gold marks, a value that was some 20% greater than national income for 1914. Inflation acted very rapidly, however: in the end of 1920 this value has been reduced to 5.4 billion gold marks57. No doubt, the most serious problem created by the Peace treaties was certainly the payment of reparations, which by virtue of Germany's weight over the world economy, turned out to become an issue of overwhelming influence for European economic diplomacy in the early 1920s58. The burden it effectively represented over the German economy have been the object of a lasting controversy we will abstain from reviewing59 , though we should observe that the empirical assessment of the burden of reparations have been much influenced by Machlup's seminal work on the issue60 . Machlup reports that reparations payments represented 10.9% of exports during 1925-1928 and 14.7% during 1929-1932, and that as a percentage of national income reparations accounted for 2.5% on average during 1924-1932. These numbers would appear very modest as compared to the ones resulting from other episodes of large transfers such as the British subsidies during the Napoleonic Wars, the French indemnity

56 Republic of Germany-Krieglastenkommission (1924) p. 30. 57 Republic of Germany (1923) p. 29. 58 "In the whole period, international financial transactions, even those involving countries not in the least involved with reparations, were powerfully influenced by the reparations problem. Reparations set the agenda for the next twenty years, and gave the whole period the character of high politization, precarious balance, or open crisis which students of international finance invariably detect and remark upon". Cf. M. de Cecco (1985) p. 47. 59 The debate on the so-called transfer problem has originated countless entries, for which an interesting survey is provided by F. W. Fetter (1968). We should also mention Keynes' contribution starting the debate, J. M. Keynes (1920) and (1922), and his later exchange with Ohlin, in D. E. Moggridge(ed.)(1983) and B. Ohlin (1929). after the war with Prussia and the US capital exports after the World War II; this would lead Machlup to observe that "it is hard to understand why some economists in the 1920s made such a fuss about the supposed severity of the German transfer problem"61. Two important observations should be made on Machlup conclusions about the burden of reparations, and the possible bearing it may have on the German inflation: on one hand, whatever the burden of reparations when seen in isolation it would be made more difficult by the exceptionally low level of real wages observed immediately after the war and the decisive posture of the German labor movement to recover the levels of 1914; this represented a major obstacle for the improvement ni competitiveness that was an indispensable requirement for the "transfer" of reparations payments. In fact, the tensions between the endeavors of the labor movement and the requirements of external balance in the presence of reparations can be thought as an important determining factor of the plunge into hyperinflation. By the same token, after the stabilization and the Dawes loan, the presence of recycling by means of autonomous capital inflows would turn the adjustment effort much easier. Second, one should have a proper measure of the burden of reparations before 1924 and of the extent of recycling after 1924. Machlup calculations refer to the period under the Dawes plan so that the implied burdens correspond to payments that had suffered a major scaling down cum rescheduling in 1924 with respect to the payments prescribed by the London schedule of 1921. Quite clearly the arguments on the impossibility of the reparations demands, and especially those by Keynes, referred specifically to the provisions of Versailles and those of the London settlement, whose burdens are not considered by Machlup. Estimates of these burdens are reported in Table 3-3 .

60 F. Machlup (1976) chapter 15. 61 Ibid. p. 385. Table 3-3 Germany: Reparations Payments, 1921-1932 (millions of gold marks)

year Exports Reparations %rep/exp. %rep/GNP 1921a 1.864.8 1.484.8 79.6 2.6d 1922 3.970.0b 3.032.2c 76.4 5.3d 1923 5.038.7b 3.310.1c 65.7 5.8d 1924e 7.816.0 281.0 3.6 0.5d 1925-28e 10.840.0 1.182.0 10.9 1.6 1929-32e 10.214.0 1.498.0 14.7 3.5 SOURCES and OBSERVATIONS: (a)values for six months between May and October as reported by J. M. Keynes (1922) p. 51. (b)Values in gold marks obtained from C. Bresciani-Turroni(1937) p. 248 and J. P. Young(1925) vol. I p. 539. (c)Due values obtained by computing 26% of actual exports and adding 2.0 billion gold marks. (d)Considering the estimate of national income for 1925 used by Machlup. (e)Values from LN(1944) p. 103. (f)Values computed by F. Machlup (1976) p. 384.

Table 3-3 considers reparations payments under the assumption that the London schedule has been fully met; this was indeed so at least until the fall of 1922. The London schedule established yearly installments that should include a fixed portion equal to 2.0 billion gold marks, approximately £111.0 millions, and another portion equivalent to 26% of German exports62. The burdens implied by these arrangements were much heavier than the ones observed for other transfer cases studied by Machlup63 and than the ones relative to LDCs debt servicing in the early 1980s64. Machlup's conclusions are therefore reversed as far as the period before the Dawes Plan is concerned. The fact that reparations demands under the London schedule appeared indeed very heavy, as repeatedly argued by German officials at the time, reinforces the hypothesis that the hyperinflation was related to a difficult, perhaps impossible, transfer problem. The contrast between the burdens under the London schedule and under the Dawes Plan is extraordinary; it provides a powerful indication that the basic "adjustment" necessary to eliminate the inconsistency between external balance and acceptable level of real wages was indeed the rescheduling of reparations.

62 J. M. Keynes (1922) p. 45 and H. G. Moulton & C.E. McGuire (1923) pp. 56-62. 63 See F. Machlup (1976) p. 393. Note that our ratios of reparations over national income are underestimated for the period 1921-1925 for we had to consider 1925's GDP; most certainly national income in these years was considerably smaller. Similar conclusions as regards the magnitude of the burdens of reparations could be obtained from a different method. There are estimates, though sharply divergent, of the total reparations payments up to August of 1924, including cash payments under the London schedule, delivery and requisitioning of merchant ships, seizure of German property and miscellaneous deliveries in kind. The Reparations Commission placed its estimate at 8,092 million gold marks and the German government at 41,442 million gold marks, a difference that could be explained by the fact the the former calculation is reportedly incomplete mostly as regards the liquidation of seized property and payments not technically defined as reparations and by differences in valuations of deliveries in kind65. The Reparations Commission, when included liquidation of German property considered the lowest price at which it could be auctioned while the Germans presented valuations based on replacement values66. If we add to the Reparations Commission estimates only the German estimates of property seizure, thus disregarding differences as regards all other payments, the total payments would by raised to 25,531 million gold marks which would represent 103% of the total value of exports between January of 1919 and August of 192467. A similar calculation could be performed using Moulton and McGuire "impartial analysis"68 of the payments made by Germany during the period from November of 1918 to September of 1922, which were estimated at 25,8 billion gold marks, not including the payments in cash under the London schedule, which represented 173% of total exports during these years. The German stabilization problem differed very fundamentally from the equivalent problem for the Successor States mostly because Germany was a large industrial country whose healthy reconstruction was a fundamental issue for the reconstruction of the world economy. The international importance of the German stabilization would be largely underestimated if we measured it only by Germany's weight on international trade69,

64 See for example A. Fraga (1985) p. 41. 65 H. G. Moulton & C.E. McGuire (1923) pp. 66-67. 66 Ibid. p.72 and appendixes D and F. 67 Using the Reparations Commission estimate as it stands we obtain 32.6%, using the German number we get 167.2% and averaging the two we obtain a round 100% of total exports in that period. The total exports during these years have been computed from C. Bresciani-Turroni (1937) p. 248 and J. P. Young (1925) vol. I p. 539, and for the period January-April of 1921, for which there are no figures, we used interpolations. 68H. G. Moulton & C.E. McGuire (1923) pp. 74-75. 69 Germany alone was responsible for nearly ¼ of European exports and approximately 28% of world since reparations payments represented a much stronger influence over international capital movements. As an illustration of the extent of this influence we should observe that the average yearly reparations installment of the period 1921-1923 would represent no less than 3/4 of the total British capital exports in 1913 and 75.6% of the combined total of British and American capital exports in 192570. The total reparations liability, fixed in London at the astonishing figure of 138 billion gold marks, or approximately £7,500 million, was so fantastic that could only be justified as "a big public exercise to convince public opinion in the victorious countries that the conclusion of an armistice with Germany did not mean millions of people had fought and died for nothing "71. This total reparations debt had been divided into three classes of bonds, the first two, the A and B bonds, would be issued in 1921 totaling 50 billion gold marks while the C bonds summing over 80.0 billion gold marks would be issue at some point in the future. If we consider that the C bonds would be eventually written off, as there had been some concrete indications, and if we deduct from the remaining debt the "impartial" estimates of Moulton and McGuire of the sums already paid, which we saw were far greater than the estimates of the Reparations Commission, we would be left with a total debt of 24,2 billion gold marks or £1,343 million. The possibility of recycling such amount through an international loan, was decisively dismissed by Keynes in 1923 as an "absurdity - an impossible and injurious chimæra", for the sum involved was "out of relation to the capacity of the investment market for securities of this kind"72. Keynes observed for example that the total stock of sterling loans outstanding for Empire, dominion, colonial and provincial governments together, that had been accumulated over a long period of time and under very favorable investment channels, totaled no more than £500 million and that the present value of all loans to foreign governments outstanding

exports of manufactured goods. 70 The total value of British capital exports in 1913 was £224.3 millions. Cf. A. I. Bloomfield (1968) appendix 1. In 1925 total British issues were £88.0 according to R. S. Sayers (1976) vol. III p.310, and American capital exports on long-term account reached 676.0 million dollars or £139 million. Cf. A. I. Bloomfield (1943) p. 340 . 71 "As was patronizingly indicated by "well informed circles" when Keynes' book came out and took the world by storm, the poor economist was taking the issue too seriously. The Germans, of course, would not be asked to pay the exorbitant sums specified at Versailles. It was all necessary to rally public opinion around the Peace Treaty". Cf. M. de Cecco (1985) p. 47.

72 In E. Johnson (ed.)(1974) p. 150. summed to approximately £400 million73. Similarly, the total reparations liability was approximately equal to the sum of all foreign issues in London made during the active ten years between 1904 and 191374. Very clearly, the consideration of an international loan without a major writing-off and rescheduling of the total reparation debt would lie, according to Keynes, "in the region of the wildest fantasy"75. The Dawes loan notwithstanding was a remarkable success76, mostly because it reduced the burdens of reparations installments to the manageable levels reported by Machlup. The loan in itself however "was not to recycle the entirety of German reparation ... but merely to prime the pump"77, as the total amount subscribed was not enough in itself to cover one full year of reparations payments78. The importance of the Dawes loan was that it triggered a massive stream of capital inflows into Germany which allowed the smooth recycling of reparations payments; long term capital inflows in 1924 were nearly five times as big as the total amount of reparations paid in this year. On average, during the period 1925-1929, capital inflows on long term account were about twice the value of reparations paid. This represented a major redirectioning of international capital movements with respect to the "normal" pre-war patterns. Considering the value of all overseas issues in the US, UK, the Netherlands and Switzerland for debtor countries, which reached $1,020 million dollars or approximately £210 million, Germany received the equivalent of £46 million, or 22% of the total, an astonishing performance for a country that had been a major capital exporter before the war79. In any event these developments certainly did not contribute to strengthen the international economy during the 1920s, and some authors even considered that the dislocations determined by the collection of reparations might be held responsible, to some significant extent, for the collapse of the early thirties80.

73 Ibid. p. 151. 74 A. I. Bloomfield (1968) p. 43. The sum of the annual values of the net inflows of capital during 1904- 1913 is £1,327 75 E. Johnson (ed.)(1974) p. 152. 76 C. P. Kindleberger (1984) p. 303. 77 Idem , Ibid. 78 In E. Johnson(ed.)(1974) p. 150. 79 The figures are from United Nations (1949) p. 26, and refer to issues only for debtor countries, thus excluding issues for Belgium, France, Sweden, and Luxemburg . Second to Germany as a host for foreign issues came Canada with $185 million and Argentina with $81 million. 80 According to Kindleberger, "reparations may not have been directly responsible for the depression ... but

3.4) Wages and Adjustment

It is difficult to deny that increases in real wages damage the cause of external balance. In this connection two sorts of facts would render very problematic the adjustment problems described in the last two sections: one was the extraordinarily depressed level of real wages observed at the aftermath of the war and the other was the no less extraordinary and simultaneous strengthening of the European labor movements after the breakdown of the German and Habsburg empires. Tables 3-4 through 3-9 summarize some of the available figures for real wages immediately following the war. The data are scanty and except for Hungary and Germany there is little information on real wages before 1920. All indications are unambiguous, however, that real wages reached their lowest point more or less at the end of the war - a little earlier in Germany and a little later in Hungary - depending on specific conditions81. Table 3-4 reports figures for Germany during 1920; the tendency is very clearly in the upwards direction for all categories, some even approaching pre-war levels. Wages at the beginning of 1920 had been within 50% to 70% of pre-war levels, which was only partly justified by the adoption of the eight-hour day in 1918. These levels were considered very low, although they represented a slight progress with respect to the levels at the end of the war. The attempts to recover from such low values were partly sucessful at least up to the collapse of the Erzberger stabilization in 1921. These gains would be defeated by the hyperinflation and the recovery of pre-war levels could only be effected after the stabilization.

together with war debts they complicated and corrupted the international economy at every stage of the 20s". Cf. C. P. Kindleberger (1973) p. 39. Similar views are held by Aldcroft, according to which "the economic consequences of debt collection may not have directly caused the slump but they certainly provided one additional impediment to the smooth functioning of the international economic mechanism in the 1920s". Cf. D. Aldcroft (1981) p. 78. 81 It is more appropriate to say that wages fell continuously until the end of the hostilities. For Germany and Austria this is indeed the end of the war or earlier, while for Hungary and Poland hostilities lasted somewhat longer; the former was mostly involved in a civil war that culminated with a Romanian invasion terminated only in 1920, and the latter fought a war with the Soviet Union until late 1919.

Table 3-4 Germany: Indexes for Real Wages, 1920 (1913=100)

Feb.1920 Jul.1920 Dec.1920 miners (unsk.) 67 94 101b miners (skill.) 67 89 94b building (unsk.) 63 84 n.a. building (skill.) 57 67a n.a. wood (unsk.) 62 - n.a. wood (skill.) 69 - n.a. metals(unsk.) 66 93a n.a. metals(skill.) 48 60a 61b State emp. (unsk.) 79 72 88 state emp. (skill.) 79 95 66 printing 55 69 71b SOURCES and OBSERVATIONS: (a)November. (b)June. From ILO (1925) pp. 13-17 and ILO (1926) pp. 76-77.

Similar patterns, though with slight variations can be observed in the other countries. Table 3-5 shows numbers for real wages in Hungary from which it is clear that the decline in real wages produced during the war was much more dramatic than the one observed in Germany. As in Germany real wages assumed an upward trend - especially after the withdrawal of the Romanian occupation army in 1920 - that was somewhat interrupted by the acceleration of inflation but that was restarted with the dissemination of indexation in 1923. Real wages averaged between 62% and 66% of pre-war levels in 1923 and despite the upward trend they would barely reach pre-war levels just before the Great Depression82.

82 ILO (1926) pp. 90-92 and D. Pap (1925) pp. 164-165. See Table 8-5 for details on wages shortly before and after the stabilization.

Table 3-5 Hungary: Indexes for Real Wages, 1918-1920 (1913/1914=100) ______Dec.1918 Dec.1919 Dec.1920 Iron/engineering(unsk.) 46 30 63 Artisans(skill.) 53 26 48 White collarsa 47 21 22 Workersa,b 84 40 40 ______SOURCES and OBSERVATIONS: (a)Average of 9 groups. (b)Average of 96 groups. From D. Pap (1925) p. 156 .

Figures for Poland are shown in Table 3-6 for wages in the first semester of 1921. The available information for earlier dates is scanty at best: an index computed with the figures for nominal wages and a index for food prices in Warsaw would indicate real wages reaching approximately 15% of their pre-war levels in the first semester of 1919 reaching approximately 50% in the beginning of 192183. The figure for 1918 is confirmed by a historian that reports that real wages in Warsaw in the second semester of 1918 had reached 17% of the real wages for the first semester of 1914 using the same price index; yet by considering an enlarged cost of living index, including fuels, rent and lighting - services for which there were subsidies - and also industrial goods, this figure is raised to approximately

Table 3-6 Poland: Indexes for Real Wages, 1921 (1913=100)

______Jan.1921 Apr.1921 Jul.1921 bricklayers 77 96 71 building (skill.) 68 88 69 building (unsk.) 92 120 110 weavers 72 81 53 spinners (female) 102 117 76 printing 82 140 95 breweries(skill.) 66 100 78 breweries(unsk.) 75 116 90 bakeries (skill.) 65 95 90 bakeries (unsk.) 66 102 110 SOURCES: From ILO (1925) pp. 116-117.

40%84. Wages recovered very strongly from these low levels up to a peak in the spring of 1921, when for many categories wages had even made substantial gains over pre-war

83 These nominal wage figures correspond to an index that includes wages paid for skilled and unskilled workers in the metal, printing and coffee industries and public works. From J. Szturm de Sztrem (1924) pp. 391-392. levels85; these gains were actually very significant in view of the adoption of the eight- hour day late in 1918. From then on the acceleration of inflation and partial wage indexation would bring real wages to levels of about 50% of their pre-war levels in December of 192386. Like in Germany, the stabilization would determine a sharp increase that would eventually establish levels comparable with those of 191487.

Table 3-7 Austria: Indexes for Real Wages, 1920-1921 (1913=100)

Dec.1920 Dec.1921 Wood (skill.) 58 108 Metals (skill.) 69 64 Metals (unsk.) 86 77 Building (unsk.) 49 106 Printing (skill.) 58 97 Taylors (male) 50 62 Taylors (female) 44 55 Bricklayers 36 86 Carpenters 35 -____ SOURCES : ILO (1925) p. 87 and ILO (1926) p. 41.

Table 3-7 reports the figures for Austria for 1920 and 1921. Again there is little indication on real wages immediately after the war; it is only observed that sliding scales made their first appearance in 1919 and that most likely slight gains were made from then to 1920; in fact these apparently small wage gains were important in view of the adoption of the eight-hour day in 191888. In any event, the real wages observed in the table for 1920 are very low and again one observes a very strong drive towards pre-war levels that were effectively reached by many categories in the end of 1921. The system of wage indexation implemented in 1921 has certainly contributed to this outcome, but it could not prevent the acceleration of inflation to reclaim some of this gains89. After the stabilization, as observed in Poland and Germany, and to a less extent in Hungary,

84 Z. Landau (1968) p. 195. 85 ILO (1925) p. 114 , J. Szturm de Sztrem (1925) p. 393. 86 ILO (1925) pp. 115-116. 87 See Table 9-3 . 88 C. A. Gulick (1948) pp. 151-154 passim . 89 ILO (1925) pp. 87-89. workers regained pre-war levels very quickly90, which actually represented a significant progress in view of the reduced working day. These violent swings in real wages are hardly explained by changes in unemployment. In fact the fluctuations in the level of employment are really very small during the hyperinflations; significant changes are only observed during austerity oriented stabilization attempts such as Erzberger's in 1921 Germany, Hegedüs in 1921 Hungary and Michalski's in 1922 Poland. For Germany, no correlation between wages and unemployment could be found, and for Austria and Poland a significant, though not very strong, positive correlation was observed91. The behavior of real wages during the inflation period seems overwhelming determined by workers' capacity to build defenses against inflation92, and these depended on the gradual adoption and improvement of wage indexation mechanisms and also on the possibilities of recontracting base wages. During the early post-war period these factors would be remarkably influenced by a number of new developments related to the strength of the labor movement, the institutional channels of collective bargaining and the overall social and political atmosphere of the early 1920s. It is especially relevant for our purposes to consider the massive incorporation of organized labour into systems of collective bargaining supervised by the government93. This is illustrated at first instance by the phenomenal increases in trade union membership after the war reported in Table 3-8. Table 3-8 Trade Union Membership , 1914-1920 (thousands) 1914 1918 1919 1920 Austria 147 413 772 901 Hungary 107 721 722† 152 Germany 2.437 2.184 6.527 9.163 Czechoslovakia 55 161 657 - Italy 962 - 1800 - Switzerland 50 177 224 - U. K. 2.400 6.645 8.024 - France 1.026 2.000 2.500 -____ SOURCES: ILO (1921a) pp. 2-3 and (1921b) p. 3, C. A. Gulick (1948) pp. 258-259, J. Vagö (1925) p. 347 and G. Bry (1960) p. 32.† average during the year.

90 See Table 9-3. 91 The of wages, unemployment and inflation is discussed at lenght in chapter 5. 92 ILO (1925) p. X. 93 C. S. Maier (1975) p. 11.

The tendency pictured in the table is very strong ni Europe, but it is also observed in all industrial countries94. It is but one indication of the deep social transformations accelerated by the war and reinforced in some countries by the breakdown of the great empires in Europe. In Austria and Hungary the increases in unionization are even more impressive if we consider the reductions in population and territories determined by the Peace Treaties: Austria in 1914 had 30 million and Hungary 21 million inhabitants; in 1919 these figures would be reduced to 6.5 million and 7.6 million respectively95. As percentages of the economically active population the degrees of unionization would be of 29.2% of Austria in 1920, 19.8% for Hungary96 in 1919 and 28.4% for Germany97. There are no comparable figures for Poland before 1925; in this year union membership reached 1,153 thousand representing approximately 16% of the economically active population98. These numbers are comparable to those of today, which is indicative of the rapidity of the transition from the backwards systems of industrial relations of the German and Austro-Hungarian empires to modern institutions. The remarkable strengthening of organized labor was simultaneous with the passing of sweeping reforms in labor legislation including, for instance, the eight-hour day, the recognition of the workers' councils and the unemployment insurance, in addition to the establishment of machinery of collective bargaining, arbitration and conciliation99. The latter is especially important for our purposes, for it bears direct relation with wage setting. Table 3-9 reports the figures pertaining to the increase in the coverage of collective agreements in Germany after the war. No comparable data could be obtained for the other countries, though the indications are that similar developments took place - with the exception of Hungary, which was an authoritarian rule - namely an astonishing increase in the coverage of collective agreements. These developments would acquire a particularly progressive character in Germany

94 ILO (1921b) passim.

95 See Table 2-2. 96 The sharp decrease in unionization observed in Hungary in 1920 is due to the defeat of the communist regime and the ascendancy of a right-wing dictatorial regime that promoted vast persecution of labor leaders and unions. On Admiral's Horthy regime's persecution of unions see ILO (1921c). 97 Considering population figures from B. R. Mitchell (1978) pp. 51-55. 98 Republic of Poland (1930) p. 329 and B. R. Mitchell (1978) p. 58. and Austria where these changes reflected not only the institutional accommodation of an increased labor activism but more importantly it reflected political compromises providing the foundations of new parliamentary democracy experiments following the revolutionary upheavals after the war. The reformist and conciliatory character of these compromises certainly reflected the concern with the revolutionary alternatives provided by the Bolshevik experience in Soviet Russia and also in Hungary. The threat of communist take-over was very concrete in 1918 -1919; attempts had been made in Austria and Germany and a communist government indeed took power in Hungary in 1919. The strengthening of the socialists, or of the social democracy, seemed the only effective alternative within a democratic government. Indeed the role of unions and socialist parties in the Weimar state, as well as in the new Austria, would be paramount; the social democrats would emerge from the war as the largest single party in both countries100 and would control most coalition cabinets in Austria and Germany during the inflation/stabilization years. Table 3-9 Germany: Collective Agreements, 1914-1924 (thousands)

Year Agreements Estabs. covered Workers covered 1914 10.9 143 1.399 1920 11.0 272 5.986 1921 - 364 8.630 1922 - 552 11.072 1923 - 718 12.290 1924 8.8 813 13.135 SOURCES: G. Bry (1960) P. 42 and P. Taft (1952) p. 285.

These developments also took place in Poland and Hungary though with some important variations. For Poland the problem of setting the proper institutional arenas for political parties and for industrial relations was a major problem not at all unrelated with their effort of nation building101. To a great extent Poland followed the progressive trends in labor and social legislation observed in Austria and Germany; despite some tensions arisen out the of the predominantly agricultural character of some parts the country, especially in the Russian and Austrian partitions, all the major gains obtained by workers elsewhere in Europe could also be enforced in Poland. The eight-hour day was

99 ILO (1921c) pp. 8-9. 100 To judge from election returns in 1919 in both countries. Cf. F. Ringer (1969) p. 29 and C. A. Gulick (1948) vol. I p. 690. 101 J. Rothschild (1974) p. 46 passim . established in November of 1918, doles and social securities were obtained in 1919 and, most importantly, the introduction of obligatory collective labor contracts in all sectors, including agriculture, was secured before 1920 was over102. For Hungary the early post-war period resulted very unfortunate. The progressive winds would affect very strongly the backwards, nationalist and militarist Hungarian society. The socialists and their unions would appear as the strongest political force emerging from the war, but they failed to vindicate the progressive aspirations of workers and could not stand the blow represented by the ratification of the Peace Treaties103. A communist government followed, the Dictatorship of the Proletariat being officially proclaimed in June of 1919. Labor legislation advanced much beyond what had been accomplished in Germany and Austria, but the violent overthrown of the Bolshevik government would bring a right wing dictatorship that would reverse all advances made. The eight-hour day, for example, would be repealed and would be reintroduced only in 1935. The backwards labor legislation, the weak union organization and not the least of it, the depressed level of wages throughout the 1920s, could be directly associated with the new regime104. Hungary apart, it seems hard to conceive such strengthening of the labor movement and the progressive tenor of the early 1920s to be compatible with a major income redistribution against labor as had taken place during the war and as seemed required by the severe adjustment problems these countries faced. In fact all social-political developments would seem to point towards a sharp increase in the labor's share of national income. The data in this regard is only available for Germany and fully confirms the conjecture: the share of wages and salaries of the national income averaged around 46.5% during 1910-1913 and in 1925-1927 it averaged a little less than 61%105. It seems very likely that the same occurred in Austria and Poland, which is more or less indicated by the fact that after the stabilization real wages made considerable gains up to the late 1920s despite the eight-hour day.

102 Z. Landau & J. Tomaszewski (1985) p. 54-56 . See also F. Zweig (1944) pp.139-150. 103 J. Rothschild (1974) p. 141 passim . 104 I. T. Berend & G. Ránki (1974b) pp. 158-163. 105 A. Jeck (1968) pp. 83-88.

It is fair to say that the principle of "the return to the pre-war normalcy", often found in the discussion around the fixing of exchange rates in the early 1920s, is commonly observed as regards the level of real wages. That pre-war levels of wages seemed a very clear target of the labor movement seems confirmed by the stated objectives of unions. Even more that that, however, workers in Germany pointed out that "as the purchasing power of gold was lower [or that the real exchange rate had depreciated], their standard of life would not be the same even if nominal wages were fixed at their pre-war rate. They further declared that their wages had been reduced to an exceptionally low level by the depreciating action of inflation, and it was high time [after the stabilization] for the injustice which they had suffered to be remedied"106. Pre-war real wages became an obvious target and in Poland it had even become legislation: in 1923 the government passed a law turning compulsory the application of sliding scales in all collective agreements provided that real wages were below the levels of 1914107. But more importantly, however, the fact that pre-war level of real wages was the target is revealed by the fact that it was quickly approached, and even regained, in every brief spell of price stability prior to the runaway phase and that, except for Hungary, pre-war levels were fully regained in a few months after the stabilization.

3.5) Conclusions

The wage problem was a serious obstacle to adjustment. We saw in section 2-6 that real wages at the end of the war fluctuated between 40% and 60% of pre-war levels and that a strong drive towards pre-war levels could be seen very early after the war. The inconsistency between external balance and the goals of the labor movement was overwhelming; this problem was at the very root of the inflationary explosion, yet it is entirely absurd to blame workers for the inflation. Capitalists could be equally blamed, if one's interest is to establish some form of guilt by association. Most importantly is to observe that inflation is a process in which every actor plays its own interest so that basically the outcome is no one's specific fault. The true challenge is the removal of the

106 ILO(1925) p. 79. 107 Ibid. p. 126. constraints that preclude the reconciliation of interests; this chapter attempted to specify inconsistencies, the following ones would show how they managed to be eliminated. Adjustment in the absence of foreign capital would be very problematic for all hyperinflation countries, problems like commercial policy in the Danubean area, the rescheduling of reparations, and modernization of agriculture, for example, were incredibly difficult to address. Yet "outside" factors like the authoritarian government in Hungary, the annexation of Upper Silesia to Poland and the Dawes Plan would either represent major improvements in these countries external positions or, as in the Hungarian case, remove the obstacles imposed to more painful forms of adjustment.

Chapter 4

Theory and practice of inflationary finance

4.1) Introduction

For many authors the collection of the so called "inflation tax" provides the main justification for the existence of inflation in genaral and of hyperinflations in particular. Most economists are, however, receptive to non-monetary causes of inflation, but for such extraordinary cases this is rarely found. Conventional views on the hyperinflations are heavily influenced by the works of Philip Cagan [1956] and Thomas Sargent [1982], which, as it is well known, carry extreme views on the nature of the inflationary process that do not enjoy this same acceptance as far as "ordinary" inflations (these being OECD type inflations and even Latin American inflations) are concerned. The experience of the 1970s and early 1980s did much to blur the frontier between what should be conceded to these extreme views, and what should be explained by other influences. This is not merely a product of economists celebrated pragmatism: there is an extensive list of suggestive similarities between the 1970s and the 1920s, including huge external shocks, large transfers, impossible debts, flexible exchange rates and high inflations1. It makes little sense, at least at a first sight, to imagine that the so called hyperinflations would have been less affected by such non-monetary influences than the semi-hyperinflations of today. Inflationary finance occupies a distinguished place in descriptions and explanations of hyperinflations, but as this chapter will try to argue, the purely monetary models of inflation display a surprisingly little explanatory power when applied to these episodes. This chapter provides a revision of these models and a number of observations and tests of their applicability to the hyperinflations. The next section reviews seigniorage maximizing models and also models of the monetary dynamics of inflation improving upon the original Cagan's model. It also checks whether the observed patterns of collection of seigniorage and the so called "inflation tax" are consistent to the predictions of these models. The poor performance of monetary models to explain the hyperinflation leads one to conjecture that after all it might have been that other non-

1 M. de Cecco (1983 and 1985); T. Balogh & A. Graham (1979); R. Aliber (1980); J. A. Frenkel (1978); and A. Fraga (1984). monetary influences were the true driving forces of these episodes. Section 4.3 advances this conjecture and considers several indications pointing towards the endogeneity of money. Section 4.4 summarizes the main fundings.

4.2) Monetary model of high inflations

There is a great variety of models in which inflation is determined solely from the demand and supply of money. These models can be distinguished by their specification of the , the process of expectations formation and the government's budget and objective function. The money demand most usually assumes an exponential specification - following the pioneering work of Cagan (1956)2 - that sometimes considers changes in real income and wealth3 and sometimes is defined in a dynamic context4. Adaptative expectations are commonly found, though this had generated objections even before the more recent efforts towards reconciling rational expectations and the autoregressive structure of money demand5. As regards the government's budget and objective function, a common alternative is to consider a government maximizing the proceeds of the inflation tax6, sometimes considering the welfare costs of inflation7. The most usual procedure, however, is to assume that, following Cagan (1956), the inflation tax should finance an exogenous budget deficit, which may be also sensitive to the effects of inflation over tax revenues, that is, to the "Oliveira-Tanzi" effect8. The great variety of models could in principle justify the wide diversity of predictions, especially as regards the dynamics of inflation. Yet, with respect to the "optimal" inflation - something that evidently only makes sense in maximizing models - it is interesting to note that the great majority of models lead to variations around the

2 There has been some experimentation with other functional forms, such as in R. Jacobs (1977a), R. Barro(1972) and J. A. Frenkel(1977 and 1979). 3 For example M. Friedman (1971), R. Mundell (1971) , A. L. Marty (1973) and E. Tower (1971). 4 As in C. Cathcart (1974) and B. Aghevli (1977) and also in some of the more recent intertemporal rational expectations models: G. Calvo (1978), R. Barro (1983) and N. G. Mankiw (1987). 5 As for example in L. Sjaastad (1976) and H. Johnson (1977). 6 As in M. Friedman (1971), C. Cathcart (1974) and R. Barro (1983). 7 As in M. Bailey (1956), C. Cathcart (1974) and A. L. Marty (1973). 8 As in J. H. G. Oliveira (1967) and V. Tanzi (1977 and 1978). See also B. B. Aghevli (1977) & M. Khan (1978) and L. Summers (1981). classical Friedman & Cagan solution, namely that inflation should be constant and equal the reciprocal of the interest semi- of the demand for money9. Yet high inflations are invariably unstable and observed rates are often higher than the "optimal" seigniorage maximizing levels, as recognized by Friedman himself10. The hyperinflations are no exception, as seen in Table 4-1:

Table 4-1 Alternative Definitions of the "Optimal" Inflation and Actual Inflations

Country "Optimal" Actual Standard deviation Period Austria 20.2 32.6 35.7 Feb.1921/Sep.1922 Hungary 46.8 29.6 26.2 Jul.1922/Feb.1924 Germany 24.9 41.8 61.0 Aug.1920/Jul.1923

Poland 39.5 52.8 61.7 Apr.1922/Jan.1924 SOURCES and OBSERVATIONS: ßs are medians from Table A4-1. Figures from J. P. Young (1925), vol.I p. 530 and vol.II pp. 322 and 349 and in J. Van Walré de Bordes (1925) p. 83.

Table 4-1 shows estimates for "optimal inflations" according to the classical Friedman & Cagan criteria, computed from estimates of the interest semi-elasticity of the money demand discussed in the appendix. More important than the large discrepancies between "optimal" and actual levels is the extraordinary variability of actual inflation rates, by consequence of which the averages for observed rates are very sensitive to the choice of period. If, for exemple, we included the last four months of the German inflation in the period relevant for the definition of the actual rate in Table 4-1, this would raise it to 1,310%, which evidently turns meaningless the notion of an "optimal" inflation. Althought it has been conjectured that the discrepancies might be due to bad estimates of the interest semi-elasticity of the demand for money11, the important pont is that no arbitrary concept of "optimal" inflation, especially when predicting a constant inflation rate, is consistent with the variability displayed by the data12.

9 That follows from maximizing the revenues of the inflation tax, namely .(M/P), subject to a money demand function with an exponential specification. 10 M. Friedman (1971) p. 853. 11 T. Sargent (1977) p. 429. 12 Alternative concepts are offered by C. Cathcart (1974), R. Jacobs (1977a) and R. Barro(1972 and 1983) for example. There are, however, two interesting alternatives, both of which derive seigniorage maximizing inflation rates that are random walks. One is provided by Barro (1983) in whose model the government's objective function includes a stochastic term as it is assumed that its willingness to pursue inflationary finance is described by a random walk. The other, recently advanced by Mankiw (1987), is based on the idea that the smoothing of tax rates and seigniorage over time implies that inflation should be also smoothed which would make it a random walk13. Promising as it seems, however, a convincing explanation of the dynamics of hyperinflation along these lines has not yet been produced.

4.3) The monetary dynamics of the hyperinflations

As one moves towards the family of monetary models of inflation built around Cagan's original work, the landscape becomes much more diffuse, as the great variety of models deliver many different stories about the dynamics of inflation. Many different uthors improved Cagan's model in many directions, as discussed in the appendix, in order to obtain better estimates for the demand for money. There has been, on the other hand, relatively less effort to explain some quite peculiar empirical aspects of the hyperinflations, most notably the observed patterns of seigniorage collection14. The way the dynamics of inflation relates to the collection of seigniorage varies according to the specifics of each model, but some common features are surely to be found. It is generally agreed that the steady state representation of the behavior of seigniorage collection - which in this case is identical to the inflation tax - is given by a Laffer curve type function, as seen in Graph 4-1:

13 That follows from the equality of the marginal of inflation today and in the future; actually the same principle through which the smoothing of consumption by consumers makes consumption a random walk. 14 Some exceptions are T. Sargent & N. Wallace (1973) and A. Cukierman (1988). S

B

F

A C D E Seigniorage

Ð ÐE ÐD

Graph 4-1: Seigniorage and the inflation tax

The graph pictures the revenues from the collection of seigniorage, or the inflation tax revenues, if expectations of inflation are correct. The curve's format implies that the same revenue can be obtained by low inflation and a high level of real money balances or the reverse: high inflation and low real balances. When the economy is out of the steady state, or when seigniorage is different from the inflation tax, the adjustment of inflation is described by the arrows in the graph. The reasoning is quite simple: if money growth outpaces inflation, of if seigniorage exceeds the inflation tax, the money issuing authority is attempting to force agents to hold more real balances than they otherwise would. Inflationary expectations, and inflation, should then be adjusted upwards and real balances would fall further. It might be, on the other hand that money growth is set equal to inflation, or that real money balances are constant, in which case if the economy is above the steady state curve in Graph 4-1, this means that the inflation tax collected at this given level of inflation is higher than what would be possible in steady state. This would imply an underestimation of inflation, and consequently an upwards adjustment of expectations15. In sum, if seigniorage collection exceeds the inflation tax, as in the region above the curve, inflation should be accelerating and conversely should be deccellerating if the economy is inside the curve. There are basically two ways by which a hyperinflation could be generated in this

15 It should be, in this case, that Ï.á.exp(-ß.Ï) > Ï. á.exp(-ß. Ïe), which implies that Ïe > Ï. If Ï=ö.( Ï- Ïe), if follows that Ï >0. model16, one is to consider a budget deficit that is larger that the maximum steady state seigniorage collection given by point F, represented by point B in Graph 4-1. This would correspond to a strictly monetary hyperinflation in the sense of no other influence intervening in the process: once the budget deficit is fixed at B, inflation would accelerate continuously. The other is when the economy is outside the curve at its right side or for points, for instance, to the right of D. Note that in this case, it is assumed that some non- monetary shock has to drive the economy to the instability region. Another shortcoming of this sort of model is that no ndicationi is provided on how the initial levels of inflation, as for example point D in Graph 4-1, were reached. In ignoring this problem one is actually doing away with the most important and perhaps the only relevant part of the problem, namely how monthly inflations of 30% or 40% developed. In any event, it is generally assumed that the hyperinflations of the 1920s corresponded to a process of the first type, a claim whose empirical verification could surely be undertaken simply by computing the amounts of seigniorage collected and the amounts of revenues through the inflation tax. Note, however, that while seigniorage collected is an empirically observed magnitude - deflated additions to high powered money - the "inflation tax" is not, since expectations are not directly observed. On the basis of money demand equations, however, one can compute the inflation tax that could be collected if inflation is correctly predicted, namely (Ï.á.exp (-ß.Ï)). By comparing this magnitude with the one for seigniorage collected one would have an indication for the direction of the adjustment of expectations or of acceleration of inflation as determined by the monetary dynamics discussed above. Table 4-2 below shows quarterly averages for the ratios between the amount of seigniorage effectively collected - changes in the money supply deflated with exchange rates - and the inflation tax under correct antecipations, and also the quarterly averages for monthly inflation rates in the respective quarter. Methodological details and sources are discussed at lenght in the appendix. Note that for ratios greater than one, i. e.

16 Some exceptions are T. Sargent & N. Wallace (1973) and A. Cukierman (1988). An explosive inflation may also take place if the adjustment of expectations and the response of real cash balances to expectations is "too fast", which takes place in the case of what has been called a "self- seigniorage greater than the "virtual" inflation tax, an accelerating inflation should be observed, and for ratios lower than one the opposite obtains, namely a deccelerating inflation. The table shows a number of high ratios early in the hyperinflation period; except for the first quarter in Austria and Poland all these quarters correspond to periods of price stability or , so that these are situations in which the economy was outside the seigniorage curve but at the left side. Other than that consistently low ratios are observed for Hungary, and ratios on the high side in Poland and Austria. In Germany after 1922-IV and in 1921-IV Austria we observe ratios greater than one that coincide with jumps in inflation, yet an explosive inflation is not observed after that; Austria would return to the inside of curve the next quarter and the German ratios would show declining values until 1923-III. Polish and Hungarian ratios show a high value in the very last quarter though for the latter this corresponded to the post stabilization remonetization of the economy. Only in for the very last quarter in Germany, Poland and Austria there is indication of these economies being well out of the curve. It should be noted, however, that these quarters encompass the stabilizations, which, by virue of the remonetization process, might have biased these ratios upwards. In any event, only in Germany an unambiguous inflationary "explosion" is observed. The ratios reveal, therefore, that these countries did not experience Cagan hyperinflations of the second sort except perhaps at their very ends; that means basically that the model does not explain how the extremely large level of inflation of the pre- explosion quarters (61% for 1922-III Germany, 42.9% for 1924-I Hungary, 57.8% for 1923-III Poland and 35.5% for 1922-II Austria) were reached. Aparently, therefore, these levels of inflation were generated by non-monetary influences. These conclusions are reinforced in the context of a simple and interesting extension of this basic framework, namely the consideration of the Oliveira-Tanzi effect. When considering an "endogenous" budget deficit one should note that government should be aware that some of the revenues it gains from inflation - if on the rising portion of the seigniorage curve -is wasted by decreases in the yield of ordinary taxation. In this

generating" inflation. Cf. P. Cagan (1956) p. 72; B. M. Friedman (1975) and D. A. Peel (1978). This possibility however is of a reduced practical interest. connection, governments should be concerned with total revenues, namely taxes plus seigniorage.

Table 4-2 Seigniorage Actually Collected as a Proportion of Steady State Levels (quarterly averages-the number in parentheses indicate average monthly inflation rates in the respective quarter)

Germany Hungary Poland Austria date ratio inflation ratio inflation ratio inflation ratio inflation 1921 - I 0.23 -3.6 -0.27 -5.2 1.07 15.0 1.24 6.6 II 3.93 0.7 0.21 -8.2 4.50 2.2 2.70 2.2 III 0.35 15.3 0.39 15.3 0.44 19.5 0.53 8.6 IV 0.72 20.0 0.47 7.4 -4.07 -1.4 1.33 64.0 1922 - I 0.21 16.4 0.29 9.6 0.26 8.9 0.77 14.8 II 0.51 9.1 0.29 11.4 0.70 6.1 0.69 35.5 III 0.69 61.0 0.43 27.4 0.70 20.5 3.67 85.5 IV 1.83 76.0 0.42 8.3 0.57 31.5 - - 1923 - I 1.60 59.0 0.16 27.2 0.76 43.3 - - II 1.37 66.9 0.40 30.2 0.62 26.7 - - III 8.1x1031 1942 0.79 59.8 0.97 57.8 - - IV - - 0.55 12.9 6.87 177 - - 1924 - I - - 0.35 42.9 - - - - II - - 4.78 2.1 - - SOURCES and OBSERVATIONS: see appendix

It has been shown that the format of the "toatal revenues" curve is similar to the one of the seigniorage curve in Graph 4-1. The peculiar features are that the maximum for total reveunes obtains at a level of inflation lower than the one that maximizes seigniorage, and that under price stability total revenues are positive and identically equal to tax revenues. The implied dynamics of inflation is also quite similar to the one pictured in Graph 4-1. Since taxes are collected on the basis of observed inflation, i. e. T=T(Ï), if the economy is above the total revenues curve, or if government expenditure G is greater than T(Ï) + Ï.á.exp(-ß. Ï), then the fiscal deficit G - T(Ï) which is identically equal to the amount of seigniorage collected - is greater than the inflation tax which is given by Ï. á.exp(-ß.Ïe), so that, as in the previous case, one would have an acceleration of inflation. Table 4-3 repeats the exercise of Table 4-2 by showing ratios between revenues actually collected as seigniorage and taxes and the revenues that could be collected at that rate of inflation in a steady state, i. e. the relevant point of the total revenues curve. Since it amounts to summing tax revenues to both terms of the ratio, Table 4-3 reproduces the results of Table 4-2 though in a reduced scale: the instability region is still at one but all ratios are now uniformly reduced. For Hungary, for exemple, the ratios does not reach one not even in the very last quarter. For Germany and Austria the economy is driven out of the curve in 1922-IV and 1921-IV respectively, when inflations registered a large jump. Yet, the tendency was for these economies to return to the curve; in 1923-II Germany appeared to be nearly on the curve and Austria well inside in 1922-II. Again an unambiguously "explosive" behavior is only observed in 1923-III Germany.

Table 4-3 Total Revenues (Seigniorage plus Taxes) Actually Collected as a Proportion of the Steady State Levels (quarterly averages-the number in parentheses indicate average monthly inflation rates in the respective quarter)

Germany Hungary Poland Austria date ratio inflation ratio inflation ratio inflation ratio inflation 1921 - I 1.77 -3.6 0.77 -5.2 0.55 15.0 0.74 6.6 II 1.17 0.7 0.53 -8.2 0.66 2.2 0.83 2.2 III 0.55 15.3 0.42 15.3 0.32 19.5 0.51 8.6 IV 0.61 20.0 0.43 7.4 0.58 -1.4 1.12 64.0 1922 - I 0.40 16.4 0.37 9.6 0.37 8.9 0.56 14.8 II 0.58 9.1 0.37 11.4 0.53 6.1 0.59 35.5 III 0.64 61.0 0.41 27.4 0.47 20.5 2.01 85.5 IV 1.06 76.0 0.32 8.3 0.42 31.5 - - 1923 - I 1.01 59.0 0.23 27.2 0.54 43.3 - - II 0.97 66.9 0.32 30.2 0.61 26.7 - - III 2.6x109 1942 0.73 59.8 0.71 57.8 - - IV - - 0.46 12.9 1.87 177 - - 1924 - I - - 0.40 42.9 - - - - II - - 0.96 2.1 - - - - SOURCES and OBSERVATIONS: See appendix.

In sum the evidence displayed in Tables 4-2 and 4-3 suggest that these hyperinflations were not generated by the necessity to collect seigniorage above the steady state values, or the values for the inflation tax. Apparently, this would have been observed, and not in an unambiguous manner, in the very last quarters of these episodes. Even if it is case of a hyperinflations of the second sort, the important conclusion is that the monetary dynamics does not explain how these hyperinflations started and how they reached the extremely high levels observed in the months preceding their entrance in the instability region.

4.3) ?

Last section presented a disapointing picture of the performance of monetary models in explaining the hyperinflations. The provocative hypothesis that the hyperinflations could be generated by non-monetary forces emerges from these findings and should surely be given a further examination. This section attempts to assess the extent to which one can legitimate consider "passive money" as a sound description of the dynamics of the money supply during these episodes. The fact that the predicitons of seigniorage maximizing models have not been borne by the evidence leaves the empirical support to monetary models of (hyper)inflation restricted to the remarkably successful empirical performance of money demand estimations. It is indeed extraordinary that money demand relationships have held their own under such extreme conditions. No doubt the success of Cagan's pioneering work have certainly played a part in the initial impulse given to the "monetarist couter-revolution" by Friedman's 1956 classic "Studies in the Quantity Theory of Money". Yet, the empirical stability of the money demand relation does not bring any implication as regards the monetary origin of inflation. Causality might certainly run both ways; the correlation in itself would establish nothing. In this respect Granger causality tests involving money and prices have been performed by authors such as Frenkel [1977] and Sargent & Wallace [1973], and their results favored strongly the hypothesis of prices Granger-causing money creation. Using wholesale prices data for Germany, Frenkel rejected the hypothesis that prices did not "cause" money and was unable to reject that money did not "cause" prices; using CPI figures Frenkel detected a two-way causality [pp. 666 - 667]. Similarly, Sargent & Wallace rejected the hypothesis that prices did not Granger-cause money creation for Germany, Austria and Hungary (though not for Poland), and did not reject that money did not Granger-cause prices for all four countries [p. 419]. Box Jenkins time series analysis were employed by Frenkel and also by Evans [1978] for the German case, and the former rejected the hypothesis of independence between money and prices [p. 665] and the latter more specifically rejected the exogeneity of money [pp. 202-204]. The latter result has been challenged by Protopapadakis [1983] who also argued that the money supply process appears exogenous with respect to the revenue needs of the government [pp. 86-91]. Steven Webb [1984; 1985]'s modeling of the money supply process in Germany concludes that, in addition to the government needs, corporate needs for credit and expectations of inflation were also prime determinants of the money supply. A second indication favouring the passive money hypothesis is the fact that the implied patterns of collection of seigniorage under passive money are consistent with the evidence presented in tables 4-1 and 4-2. To see this consider that significant inflationary shocks are generated outside the monetary sector, as one knows was exactly the case in the twenties. Jumps in prices (in the exchange rates for example) then catch both the public and the central bank by surprise. Note that in these conditions prices have gone up before the increases in the money supply necessary to accommodate the shock have been implemented, so that the "surprise" does not imply in any extra seigniorage collection. Yet, the inflation tax is effectively collected, no matter the speed of adjustment of agents' expectations. The amounts collected can simply be read in Graph 4-1's curve, if expectations adjust very fast. Since the seigniorage revenues have not materialized because the Central Bank was surprised it follows that it is a charateristic feature of non- monetary shocks that the ratios of tables 4-2 and 4-3 - i. e. between seigniorage and the inflation tax under correct antecipations - fall below one. The hesitation of the central bank in accommodating the shock - which exactly what produces ratios below one - should produce a monetary stringency i. e. high real interest rates or credit rationing, as indeed observed in these episodes. Therefore, if inflation is predominantly governed by non-monetary shocks the economy should remain mostly inside the seigniorage (or the total revenues) curve. Another indication of the the feasibility of the passive money hypothesis is provided by Table 4-4 assessing the extent to which budget deficits explain the expansion in the money supply. The reasoning is the following: after a non-monetary shock the amounts of seigniorage, which are equal to the budget deficit, are lower than the value of the inflation tax, which generates a monetary stringency as the central banks takes some time to accommodate the shock. Banks of issue working under the "real bills" doctrine would then expand the money supply discounting private bills, thus solving the stringency and collecting seigniorage that the government abstains from collecting once the budget deficit, or the discounting of government bills at the central bank, is assumed fixed. The relative importance of private bills vis-à-vis government bills - the floating debt - provides then a measure of the importance of this mechanism for the expansion of the money supply. Table 4-4 shows actually the importance of increases in the floating debt as determinants of the money supply.

Table 4-4 Increases in the Floating Debt as a Proportion of the Increases in the Money Supply (quarterly averages)

date Germany1 Hungary2 Poland2 Austria3 1921 - I - - 1.38 - II 1.91 - 1.29 3.20 III 1.75 - 0.95 1.05 IV 0.84 0.21 0.56 0.74 1922 - I 0.80 0.51 0.52 0.75 II 0.94 0.67 0.06 0.51 III 0.74 0.07 0.65 0.60 IV 0.60 0.46 1.01 0.54 1923 - I 0.56 0.80 1.03 - II 0.71 0.43 0.72 - III 1.01 0.38 0.95 - IV - 0.43 0.88 - 1924 - I - 0.50 - - II - 0.53 - - SOURCES and OBSERVATIONS: (1)Considering only floating debt held at the Reichsbank as proportion of the increases in note circulation plus demand deposits, from J. P. Young [1925, vol.I, pp. 527-529]. (2)Figures from J. P. Young [1925, vol.II, pp. 347-348 and 321-322]. (3)Figures from J. van Walré de Bordes [1924, p. 54].

Table 4-4 reveals that monetary expansion in excess of the government budgetary needs is very often observed. For Hungary the ratios are consistently low indicating that "private inflation", or note issuing against credit creation through discounting of "legitimate" trade bills, was the more important source of money creation during the whole period17. This is also true for Austria18. For Poland, high numbers for the first three quarters of 1921 and after 1922-IV are observed. For the earlier period this could still be associated with aftermath of the war with the Soviet Russia, and for the later period the higher ratios are consistent with the significant increase in government investment expenditure (and budget deficits) after the collapse of the Michalski's stabilization experiment and the annexation of Upper Silesia in the summer of 1922. Government deficits were the main determinant of money creation from then on, but for the last three quarters of 1923 "private inflation" was still significant. For Germany one observes especially high ratios in 1921-II and III, a period in which money creation was held off but reparations payments under the London schedule precluded the corresponding fiscal restraint. The ratios are generally high for Germany indicating that was indeed the major determinant of money creation; but as for Poland "private inflation" remained quite significant throughout 1922 and 1923. The importance of budget deficits as determinants of the money supply in Germany and Poland in itself is not inconsistent with inflationary shocks being generated from non-monetary forces, for what might be taking place is that government expenditure would be adjusting to the availability of funds created by the seigniorage generated in accommodating the current levels of inflation. The government could very well perceive that as the bank of issue accommodates a shock it generates sizeable amounts in the form of seigniorage, which would ultimately benefit these bank's shareholders. Thus, it might surely be that governments raise expenditure to capture these funds; the levels of expenditure would be endogenous. This can also be subject to verification; it is fortunate that Poland and Germany are precisely the two countries for which there are figures available for government expenditure on a monthly basis. If the level of government expenditure adjusts fully to the availability of seigniorage one should expect the former to be always on the total revenues curve, so that the relation between government expenditure and inflation would be described by a

17 This finding is in full accordance with the detailed account of E. Boross (1985) of the activities of the Hungarian Note Institute during the inflation period, esp. pp. 208-209 . 18 The high ratios observed in 1921-II and III are due to the fact that up to this point the discounting of Treasury bills was not distinguished from private bills and when this started to be done we observe a large "statistical" increase in the floating debt at the central bank. J. van Walré de Bordes (1924) p. 54 ff. parabola, i. e. it would have the shape of the total revenues curve. If, instead, government expenditure adjusts only partially, money creation against "real bills" would take up the "slacks" and place the economy always on the curve. The relation between government expenditure and "private inflation" is subtle: if the level of government expenditure is low, presumably in the beginning of the process, both expenditure and "private inflation" could move in the same direction so as to approach the economy to the total revenues curve. But as expenditure is progressively adjusted upwards the "slack" under the curve is reduced and expenditure and "private inflation" begin to "compete". In this case government expenditure most likely "crowds out" credit creation against "real bills". In this case a negative correlation would be observed between the two, while for the first case (low levels of expenditure/low levels of inflation), a positive correlation can be observed. These possibilities, along with the exogeneity of government expenditure, could be given a preliminary empirical check by means of the estimation of the following equation: G(Ï) = a.Ï2 + b.Ï + c + d.( B/P)

If the relation between G and Ï is described by a parabola it should be that a<0 and b,c>0. The coefficient for the "private inflation" variable - here measured as the real value of credit extended to the private sector ( B/P) -would be negative, i. e. d < 0, if the economy is close to the total revenues curve, and could be positive if the economy is inside the curve. Alternatively, if the hyperinflation is governed by a "helicopter drop" process, or if uncontrolled additions to the money supply determined by a huge budget deficit provide the driving force of the process, then G should show no correlation with inflation, so a = b = 0, and neither with the amount of credit given to the private sector. The results of the estimation of the G(Ï) equation are reported in Table 4-5. Table 4-5 reports regressions for Germany and Poland. The Polish equation includes a trend term which has to do with the fact that Poland as a country was created in 1918; one observes during the first years of the new republic, at least until the mid 1920s, a continuous growth of the public sector as natural part of the process of nation building. A simple yet certainly imperfect way to control for that is to introduce the trend term which appears in th table as positive and significant. The "private inflation" variable was the real value of the change in the stock of commercial bills and advances extended to the private sector. All equations include dummy variables accounting for a few outliers observed in the series for G.

Table 4-5 Regressions of Government Expenditure on Inflation and "Private Inflation" (t statistics in parentheses)

country aÏ2 bÏ const. d B/P dummy trend R2 DW Germany1 -0.07 22.3 459.7 -1834 394.8 - 0.751 1.42 (-4.88) (4.93) (10.1) (-2.63) (4.96) Poland2 5.15 -29.5 45.6 25.0 41.9 2.13 0.875 1.71 (1.56) (-3.42) (11.5) (1.72) (4.34) (5.54) Poland2 - -18.5 42.1 - 39.7 2.59 0.844 1.63 (-5.21) (10.9) (3.93) (10.3) Poland2 - -21.6 19.1 -59.3 44.2 4.16 0.875 1.69 (-4.60) (1.94) (-1.12) (4.39) (4.38)

SOURCES and OBSERVATIONS: (1)Government expenditure data in millions of gold marks deflated with exchange rates. The period considered was January 1921 to June 1923. The figures are from Republic of Germany[1924, p. 32]. The "private inflation" variable was the real value of the change in the stock of bills discounted and advances extended to the private sector as reported in J. P. Young [1925, vol.I, pp. 526-529] deflated with exchange rates. (2)Government expenditure data in millions of zloty for January 1922 to April 1924 from Republic of Poland [1926, pp.173-177]. The "private inflation" variable considered was the real value of the change in the stock of bills discounted to the private sector from J. P. Young [1925, vol. II, pp.348-349] deflated with wholesale prices.(4)For sources for price data see Table 2.

The regression results for Germany provide full support for the hypothesis of government expenditure adjusting to changes in inflation rates; the signs are the ones predicted, namely a<0 and b>0, and all coefficients are significantly different from zero at 1%. The hypothesis of an exogenously given level of government expenditure is rejected. The results for Poland are less clear, which to a significant extent is explained by the small size of the sample, which includes obsrvations only for the high inflation period. A negative correlation between G and Ï is observed suggesting that the sample includes observations in the declining portion of the curve.

4.4) Summary and conclusions

This chapter reviewed the monetary models of inflation that are usually assumed to describe the hyperinflations and considered their empirical relevance. Theories of "optimal" - seigniorage maximizing - inflation were shown to be inconsistent with the extreme variability of inflation rates observed in these episodes, and the observed patterns of collection of seigniorage and the inflation tax were shown to be inconsistent with the descriptions of the dynamics of inflation provided by models of the Cagan family. In fact, it was shown that the monetary dynamics could only have had some effect at the very end of these episodes, most likely in Germany. This is, however, hardly a victory for monetary models since no explanation is provided on how the "pre-explosion" rates of inflation were reached (German inflation averaged between 60% and 70% monthly for the quarters before she fell into the instability region). This poor record leads one to conjecture on the role effectively played by money in these episodes. Several indications are then provided that point towards the hypothesis of passive money, and the idea that inflation was governmed by shocks originating from the outside of the monetary sector. In fact, the hypothesis of a passively determined money supply is consistent with the evidence presented that seigniorage revenues fell most often below the amounts collected as inflation tax. Causality tests were shown to be consistent with "passive money" and also the fact that monetary expansion was very often far in excess of the government budgetary needs points likewise. Where budget deficits seemed to governed the money supply, namely in Poland and Germany, it was possible to show that government expenditure seemed to adjust according to the availability of seigniorage funds created by the accommodation of non-monetary shopcks. In sum, the evidence presented in this chapter provides no support for the presumption that the collection of seigniorage was the one and only purpose of the four hyperinflations examined. These governments not only did not maintain inflation at their "optimal" levels, but they also failed even to reach the total revenues (seigniorage) curve. These conclusions certainly help to do away with preconceived ideas about the hyperinflations, but they provide little information on how these episodes were generated. This is a challenge yet to be properly faced.

Appendix

The computation of the magnitudes of the inflation tax (and the ratios reported in tables 4-2 and 4-3) is crucially dependent on assumptions regarding the money demand function, or more precisely - if we accept the usual exponential specification (á.exp(-ß.Ð) - on the estimates of the parameters: á and ß, respectively the demand for money at zero inflation and the interest semi-elasticity of the demand for money. For á we had to consider the observed values for the years imediately following the stabilization - 4,200 million gold marks for Germany, 394 million gold crowns for Hungary, 550 million zloty for Poland and 543 million gold crowns for Austria - since estimates for this parameter are not usually reported in money demand equations. For ß, on the other hand, there are many different estimates. Since Cagan's seminal work on money demand equations during the hyperinflations there has been more than one dozen reviews, refinements and replications of Cagan's results using the most varying methodologies19; Table A4.1 reports a somewhat arbitrary sample of estimates of ß obtained in several of these revisions. Table A4.1 Alternative Estimates of the Interest Semi-Elasticity of the Demand for Money (1) (2) (3) (4) (5) (6) (7) (8) country Cagan Khan Jacobs Khan Frenkel Jacobs Jacobs Sargent median mean Austria 8.55 5.41 7.67 4.50 - 7.71 2.78 0.31† 4.96 4.88 Hungary 8.70 1.09 - 1.90 - 3.88 2.37 1.84 2.13 3.23 Germany 5.46 1.12 3.70 4.34 3.51 4.34 3.03 5.97† 4.02 3.34 Poland 2.30 1.23 - 2.53 - 3.65 2.62 2.53 2.53 2.48 † Not significantly different from zero. SOURCES and OBSERVATIONS:( 1)P. Cagan [1956, pp. 43, 45]. (2) M. S. Khan [1975, p. 359]. (3) R. L. Jacobs [1977b, p.118]. (4) M. S. Khan [1977, p. 823]. (5) J. A. Frenkel [1979, p. 86]. (6) R. L. Jacobs [1975, p. 343]. (7) R. L. Jacobs [1977a, p. 292]. (8) T. J. Sargent [1977, p. 447].

The estimates for each country reported in Table 1 are sensitive to the choice of methodology, but except for a few odd estimates - such as for example Sargent's for Austria (which is not significantly different from zero), Cagan's for Hungary and Khan's1975 for Germany - there seems to be a fair amount of consistency. Any one

19 A critical survey could be found in S. B. Webb(1983) . choice for purposes of computation would be arbitrary, and would reflect a judgement as regards methodology. Simplicity appears to be a safe criterion, and perhaps the simplest possible choice would be the estimates obtained considering Cagan's basic model corrected for serial correlation. This would leave aside Jacobs[1977a] and Sargent[1977] who consider different models. Cagan's own estimates, as well as Jacobs[1975], show strong serial correlation, especially as regards Germany and Hungary20. The remaining estimates were obtained by procedures that were attentive to this problem: Khan[1975] simply corrected Cagan's original estimates by considering that residuals followed a first order autoregressive process. Jacobs [1977b] reestimated the equations for Austria and Germany correcting for specification errors, from which he obtained a substantially higher value for the estimate for Germany. Khan [1977] produced new estimates considering the possibility of a variable speed of adjustment for money balances, and Frenkel [1979] reconsidered Cagan's model using the forward premium on foreign exchange to measure expected inflation. It is significant that by considering only the latter estimates our choices would not be much different from what is expressed by the medians and means: a value around 5.0 for Austria, between 3.5 and 4.0 for Germany, about 1.5 for Hungary and a little less than 2.0 for Poland. Although essentially an ad-hoc procedure, by using medians for purposes of computation we do no violence to these authors efforts, though it should be kept in mind that each estimate was obatined in a different context and that these medians are not really meaningful in any theoretical sense. In fact differences between medians and averages, and between these and the estimates proposed by Khan [1977], Frenkel [1979] and Jacobs [1977b], are small enough to have nearly negligible effects in our results21. In using these medians for computing "optimal" inflations one has to note that the time dimension of the "optimal" inflation should be the same as the one of the data used for the estimation of the interest semi-elasticity of the demand for money, which in this case is monthly. This is often overlooked leading to serious inconsistencies. Money

20 Durbin-Watson statistics for Cagan's model produced by M. S. Khan(1975) p. 358 and for Cagan's model corrected for problems related with structural specification see R. L. Jacobs(1977b) p. 343 . 21 It is quite significant that the ranking of the estimates is exactly the one one should expect a priori. Austria and Germany, the more open and financially developed economies, would show the largest elasticities, while the lowest ones would be observed in the more agricultural and financially backward economies. See on this issue D. A. Nichols(1974) demand equations generally use monthly, quarterly or annual data, so that the implied "optimal" inflation should have this same time dimension. Friedman himself seemed confused with the issue: while computing "optimal"inflation rates on an annual basis considered Cagan average estimates of ß "converted" for an annual basis to be around 0.5, from which the optimal annual inflation rate would be 200% yearly22. Cagan's average estimate for ß was 4.68, from which the "optimal" inflation would be of 20.4% monthly or approximately 892% yearly. Friedman's mistake was observed by R. Barro23, and has been reproduced here and there in the inflationary finance literature24. As regards the comparison between estimates of "optimal" inflations and actual rates it is interesting to note that Cagan compared his estimates of the "optimal" inflation with the average compounded inflation rates for the hyperinflation period, according to his definition; this period is different from the one utilized for the estimation of the interest semi-elasticity of the demand for money. He defined the hyperinflation period as starting the month in which prices rose by more than 50% and as ending at the month it falls below that number and remains so for at least an year. Cagan used longer period for his estimates of money demand equations generally including more observations for the months preceding the hyperinflation period. This meant to include 10 more observations for Austria , 8 more for Hungary and Poland and 23 more for Germany25. In Table 4-1 we considered for purposes of calculation of actual inflations the longer period, namely the period covered by the figures used for the estimates of ß and á. The value of seigniorage collected was computed by deflating with exchange rates the additions to the money stock. The sources used for tables 4-1,4-2 and 4-3 were: for Germany money supply figures from J. P. Young [1925, vol. I, pp. 527-529], converted in gold marks with exchange rates from F. Graham [1930, pp. 156-158], and tax revenues from Republic of Germany [1924, p. 32] and Table 8-6. For Hungary money supply figures from J. P. Young [1925, vol.II, pp. 321-322], exchange rates from L. L. Ecker-Rácz [1933, p. 61] and tax revenues considered annual figures from Table 8-3

22 M. Friedman (1971) p. 851. 23 R. G. Barro (1972) pp.988-989. 24 See, for example, M. S. Khan & M. D. Knight (1982) p. 348 ff. 6. 25 P. Cagan (1956) pp. 26, 43 and 59. evenly distributed by quarters. For Poland money supply figures from J. P. Young [1925, vol.II, pp. 347-348] and exchange rates and tax revenues from Republic of Poland [1926, pp. 126 and 173]. For Austria money supply and exchange rates figures from J. van Walré de Bordes [1924, pp. 46-50 and 116-139] and tax figures considered annual figures from Table 8-3 evenly distributed by quarters.

Chapter 5

Inflation and adjustment

5.1) Introduction

The basic message of the last chapter was that inflationary finance played a much less active role to the hyperinflation processes than usually assumed, a point to be also emphasized in Chapter 7. The crucial question that emerges then is what alternative explanations there are "outside" the monetary sphere. Indeed, since the releasing of the brakes does not create movement1 the case against the Cagan/Sargent view of the fundamental causes of the hyperinflations can only be sustained if an acceptable alternative is provided. This chapter takes over this challenge. The model developed in this chapter is an attempt to rationalize the problems described in Chapter 3. No claims for generality are advanced; the model is conceived as a description of this particular set of relations and circumstances in their very historical context. Its basic concern is the generation of high inflation by the perverse combination of overwhelming adjustment problems and an irresistible pressure from a much strengthened labor movement to regain pre-war levels of real wages. "Inconsistencies" of this sort have been extensively modelled; they have been normally associated with theories, that have been termed "structuralist", advanced to explain chronic inflation in Latin America2, but have been extended in many directions by a number of recent models3. This chapter's model considers these inconsistencies with two additional ingredients: (i) flexible exchange rates and the possibility of "vicious circles", which is one of the characteristic features of the early 1920s and also of the 1980s4. (ii) inflationary "inertia" created, for instance, by the adoption of backwards wage indexation, and progressive dollarization. An interesting feature of this model is that the hyperinflation is not generated by arbitrarily placing the economy on some unstable path

1 As observed in this very same context by Joan Robinson (1938) p. 512. 2 A classical example is J.H.G. Oliveira (1964) 3 See for example L. Taylor (1979). W. H. Branson & J. J. Rothemberg (1980); T. Gylfason & A. Lindbeck (1984); E. Bacha & F. L. Lopes (1984); A. Canavese (1982); S. G. Turnovsky (1979); F. Modigliani & T. Padoa-Schioppa (1978) and more speciafically C. P. Kindleberger (1985). 4 As observed by M. De Cecco (1983). of a dynamic system but by cumulating shocks and pressures onto an inflationary process with "memory". It is important to note that these hyperinflations were not "explosive" inflations except in the last four months of the German inflation and some very special circumstances contributed to this outcome, as seen in detail in Chapter 10. By and large the models developed during the last decade to account for the experience of some exceptionally high inflations in Latin America during the early 1980s - at least one of which a hyperinflation according to Cagan's definition - provide a rich and powerful description of the "classic" hyperinflations. This is actually the major purpose of this chapter. The chapter is organized as follows: the next section sets up the basic model, obtaining an equilibrium level of inflation and real exchange rates (real wages) from an external balance relation and a price equation carrying a wage push term and "inertia". Section 5.3 studies the repercussions of external imbalances and considers the issue of monetary accommodation. Lastly, section 5.5 is addressed at providing econometric support for the model, though it is observed that the lack of data for some key variables allows but a partial testing.

5.2) A model of inflation in an open economy

5.2.1) External balance Consider an economy that produces one single composite tradable good out of labor and a foreign input whose price is assumed equal to one for simplicity. The following identity can be written: P = m.(b.w + c.e) (1) where P stands for output price, m represents the mark-up factor or the margin, b and c are the labor and foreign input requirements per unit of output and w and e are the nominal wage and the exchange rate. From equation (1) a simple linear relation between the real wage and the real exchange rate can be obtained:

(w/p) = áo - á1 . (e/p) (2) where áo = (1/b.m) and á1 = (c/b). One should be careful with the notion conveyed by equation (2) that increases in real wages necessarily reduce real exchange rates or that, as often observed, in order to increase competitiveness a reduction in the standard of living must be produced. In this simplified model substitution in consumption and in production are not considered nor changes in productivity, structural adjustment, and changes in profit margins. These issues belong to the discussion of lasting solutions for "fundamental" imbalances which, for simplicity, will not be discussed in the context of the short run dynamics of inflation. Short-term external balance is described by a balance of payments equation given by:

ße.(e/p) + ßu.ut + ä.(rt- r*t - êt) = R (3) where the ßs and ä are positive coefficients, r and r* nominal interest rates home and 5 abroad, ut the unemployment in excess of the natural rate and R is a shift factor . The terms on ß corresponds to the trade balance, which is positively related to the real exchange rate and to the unemployment rate; the term on ä establishes the capital inflows are triggered by differences between the rates of return of securities at home, rt - êt and abroad, r*t. It will be useful to consider that exchange rate depreciation is given by the following expression:

êt = Ï t + î.{ øe - (e/p)} (4) where øe is to be considered the long run or "normal" real exchange rate. Expression (4) says that exchange depreciation6 is, in principle, equal to inflation but it might differ if the real exchange rate is not at its long-run equilibrium level. This is a common assumption in recent models of exchange rate dynamics that was modified to consider an inflationary environment7. The "long run" real exchange rate will be defined by the following expression:

ße. øe+ ä.(rt- r*t) = R (5) according to which øe is defined as the real exchange rate that is compatible with external

5 Note that we could write the current account as ßo + ß1.(e/p) and the capital account as äo + ä1.(r-r*+Ï), in case of which ßo and äo would correspond to autonomous elements. The reopening of international capital markets, for example, would be like an increase in äo which would be represented by a reduction in R. Similarly, the annexation of a territory which maintains a trade surplus with the outside world would be like an increase in ßo which is also like a reduction in R. 6 We are implicitly assuming covered arbitrage or rational expectations as we are treating expected depreciation as equal to actual depreciation. 7 For example in J. A. Frenkel & C. A. Rodrigues (1982) p. 6 and R. Dornbush (1976) pp. 1163 and 1167. balance when expected depreciation is equal to zero, or external balance at fixed exchange rates, and when unemployment equals the natural rate. The expression conveys the notion that in the long-run, external balance should obtain under the gold standard. This is surely a fair description of the attitudes of these years, as extensively discussed in Chapter 2. Finally, combining (3), (4) and (5) there results an expression for external balance as as function of (e/p) t , Ï t and rt- r*t:

(e/p) t = (1/ße) . {R- ä.(r t - r* t)} + {1/( ße + ä. î)} . {ä.Ï t - ßu(ut)} (6)

5.2.2) The dynamics of inflation The key for the dynamics of inflation, and the possible occurrence of "spirals", is the interaction between exchange rate dynamics, as given by expression (4), pricing decisions, namely the determination of profit margins, and the behavior of wages. To see how these factors interact it is necessary to rewrite equation (1) as follows:

P t =mˆ + q.wˆ t + (1- q).eˆ t (7) for è representing the share of labor costs on unit price. Usually wage determination is described as governed by three factors: (i) the "inertial" factor stemming from the fact that nominal wages suffer periodical readjustments, often automatically given by some indexation provision, (ii) pressures related to the desired level of real wages and the union's bargaining strength; and (iii) the level of employment. The division between (i) and (ii) serves the only purpose of distinguishing from the analytical point of view the process of defending from past and future inflation and the real wage bargaining process proper. There are many alternatives to model wage indexation; one simple alternative that is commonly found in countries with chronic though not hyperinflationary levels of inflation is to consider full, or even partial, backwards indexation. Another alternative, more appropriate to the hyperinflation environment is to consider wages as dollarized, or readjusted according to exchange rate depreciation. In fact, as documented in Chapter 6, it can be argued that, along the hyperinflation process, a transition was made from backwards indexation to a dollarized system. Equation (8) considers the extent to which indexation provisions are adopted as an institutional factor related to the structure of labor relations; it is assumed to be described by a parameter ë, representing the degree of inflationary inertia. It also considers that wages are partly indexed to observed inflation - which amounts to past (last month's) inflation - and partly to exchange depreciation. The parameter ã that stands for the degree of dollarization, is assumed to be positively related to inflation.

t = ë.{(1- ã (Ï)).Ït-1 + ã (Ï).êt-1} + (Ï).{w - (w/p)t} - ó(ut) (8) Equation (8) includes the negative effect of the level of unemployment and also a wage push factor according to which nominal wages accelerate according to an adjustment factor if the current real wage is lower than a target real wage defined as w 8. This rule may appear mechanical and convey the idea of systematic fooling of workers demands. One form of preventing this departure from rational behavior is to assume that the adjustment factor is positiv ely affected by inflation. This seems to represent fairly well the strong attachment of the labor movement in the 1920s with pre- war levels of real wages that discussed in Chapter 39. The interaction of exchange rate dynamics and wage determination is crucially affected by pricing decisions, or the speed with which prices respond to changes in costs. By following the usual alternative of considering mark-ups as constants, in a context of flexible exchange rates, one establishes a "spiral", in the presence of adverse external shocks, in which exchange rates affects prices and then wages, which would act residually. Mark-ups might surely be affected by other factors: it is generally found that mark-ups respond to , though with uncertain sign10, and it is also common to observe that under high inflations price variability might induce additional "defensive" profit margins. Yet, these are empirical issues to be considered in section 5.5 ahead.

Now using the expressions for t and êt given by (8) and (4) in equation (7) and using equation (2) to express real wages as their corresponding real exchange rates the rate of inflation can be written as:

8 Note that since in this model the level of employment is constant the level of real wages define the share of labor in income. The target wage in this connection should be interpreted as a "fair" income distribution that workers are reluctant to depart from in either direction. 9 During the war real wages had fallen to levels of about half of pre-war levels in all four countries, which was regarded as one of the "dislocations" generated by the war. After 1918 a much strengthened labor movement actively pursued the recovery of 1914 wages as shown in Chapter 3.

Ït = Öi + á1 .{(e/p)t - øw } + è'.î.{ øe- (e/p)t} - ó(ut) (9) where è' =(1-è)/è and Öi = (ë.(1- ã).Ït-1 + ë.ã.êt-1) stands for the inertial components of inflation as given by indexation and dollarization. Note that equation (2) is used to express the wage gap in terms of its corresponding real exchange rate; the parameter øw corresponds to the real exchange rate associated with w the target real wage. According to equation (9) two main factors are responsible for inflation namely inflationary "inertia" and "fundamentals", which in this particular case relates to incompatibilities between target wages and external balance and, of course, the conventional Phillips' Curve effect. Equation (9) describes the way by which inflation renders wage demands compatible with desired profit margins, exchange rate determination and the inertial characteristics of the inflationary process. This sort of description of inflation has been used in modern restatements and improvements of structuralist theories developed in connection with Latin American inflations11; it is also very similar to the trade-offs explored by Modigliani and Padoa-Schioppa in connection with Italy12.

The role of the two "targets" øw and øe is crucial for the determination of inflation. If, for example, øw > øe , then the level of wages required to achieve external balance would be lower than the one workers would consider as fair, or under the fair wage the economy would enjoy a payments surplus. That is not much of a problem as either the fair wage can be easily revised upwards or the payments surplus can be used in capital exports, in freer trade regimes or merely in the accumulation of reserves. If the two targets were fully compatible, or if øw = øe, it would be that, in equilibrium, or when

êt = Ït = wt, all targets would be met or e/p = øe = øw; inflation in this case would be entirely determined by its inertial characteristic. If the degree of inertia ë is less than one then the "long-run" equilibrium or the "steady state" - for which Ït = Ït-1 - would be a state of zero inflation13.

10 L. Taylor (1986) p. 6. 11 For example L. Taylor (1979) ch. 5 and A. Lara-Resende (1979). 12 F. Modigliani & T. Padoa-Schioppa (1978). 13 This "steady state" might be of little relevance for economies subject to high indexation. Considering, for instance, an economy experiencing a monthly inflation rate of 20%, no dollarization and ë= 0.90. The "steady state" would obtain at a zero inflation yet it would take a very long time to be reached. It would The real problem arises when øe > øw, or when wages compatible with external balance are lower than those demanded by workers as fair. Since exchange markets are auction markets and firms are generally price setters workers become the weak link of the chain, or they act more or less residually given what has been established by the former. External balance always obtains for the market for foreign exchange always clear at some price. Firms pass these new quotations immediately to prices but workers are granted automatic readjustments (if indexation arrangements are in operation) that are either lagged or partial so that exchange depreciation does reduce real wages. As workers realize their loss, or that a wage gap has been opened, they react by pushing nominal wages up; since producers pass this to prices in full inflation is generated. So basically a "gap" between target and actual wages can be sustained so long as a chronic inflation is maintained. That happens not exactly because workers are "fooled", in the sense of having less than rational expectations, or having too rigid wage adjustment rules, but essentially because workers are price takers. Their reaction might certainly be an increase in , but even so their demands would always be frustrated because the macroeconomic compatibility of external balance, desired profit margins and target wages would always assign the burden of adjustment to price takers. Effective gains in real wages, or the avoidance of losses, can only be obtained at the expense of profit margins for there is no way to circumvent the external constraint.

5.2.3) Equilibrium These issues can be more clearly explored if one considers the equilibrium configuration in this model and its implied dynamics. In this connection it will be convenient to rewrite equation (9) as:

(e/p)t = [1/( . á1 - è'. î)].[( .á.øw - è'.î.øe) - Öi + Ït - ó(ut)] (10)

The slope of relation (10) on a (Ï, e/p) space, or the sign of the relationship between inflation and the real exchange rate depends on the term [ .á1 - è'.î] that measures the relative strength of the wage push vis à vis the foreign exchange push.

take about one year to have partial indexation reduce inflation below 6% a month.

When (e/p) rises (or wages are reduced) workers force nominal wages and thus inflation up according to ; meanwhile as (e/p) approached (or surpassed) ø e exchange depreciation would slow down (or an appreciation would ensue) reducing inflation. The net effect of these two influences on inflation is given by the term [ .á1 - î.è'] and stability would require it to be positive or the wage push to dominate. That means that inflation would be positively related with the real exchange rate (or negatively with the real wage), which is, in fact, confirmed by the empirical evidence presented in section 5.5. Graph 5-1 shows equations (6) for external balance and (10) for internal "balance" labeled as BP and PP respectively. The PP curve is upward sloping because it is assumed that [ .1á – î.è'] >0. For the BP curve the reasoning is straightforward: enhanced competitiveness should be matched by capital outflows which, under constant interest rates, are produced by expectations of more rapid depreciation or by increased inflation. Note that Graph 5-1 shows a long-term equilibrium without inflationary inertia and without adjustment incompatibilities or for øw = øe . It is easily verifiable from equations (6) and (10) that both curves cross at their intercept with the e/p axis at the long run equilibrium øe with zero inflation.

PP

e/p A

C BP D B øe

Ï Graph 5-1: Equilibrium under zero inflation

The relative slopes of the two curves is what ultimately secure the existence of equilibrium in the presence of incompatibilities and inertia. In fact the BP curve needs to be steeper which means: [1/( .á - î.è') ] > [ä / (ß + ä.î)] (11) or that the slope of PP be greater than the slope of BP. This is very likely the case when and î are close (and > î) and it is certainly the case when the sensitivity of capital movement to interest rates is low in absolute terms or relatively to the sensitivity of the current account to changes in the real exchange rate. The condition expressed by equation (11) is likely to be violated in economies which are very open from the financial point of view and where international transactions in capital account predominate over those in current account. This does not seem to be the case for any of the countries experiencing hyperinflation. The condition expressed by equation (11) and also our assumption that [ .á – î.è']>0 are both plausible and both most likely will hold in "well behaved" economies. It must be recognized, however, that there are no a priori reasons to justify that. It is true that it is not difficult to produce unstable models if one violates these conditions. In such circumstances it would not be difficult to conceive situations characterized by explosive inflations, yet it is less easy to find plausible economic justifications for instability in the mathematical sense. The truly meaningful challenge is to understand how big inflations are built in economies that face problems, sometimes dramatic ones, but no pathologies. Besides, an "explosive" inflation is a very rare occurrence and one of little empirical importance, as argued in several contexts in this work, even for these hyperinflation cases. It is only observed during the last four months of the German inflation, and for very special reasons, as argued in Chapter 10. No such "explosion" is observed in Austria, Hungary and Poland at any moment, which suggests that mathematical instability is probably not involved in the process. The comparative statics results are mostly the expected ones: inflation and real exchange rates are higher if inertia is stronger (say a higher ë) or if the country's external position deteriorates (higher R). Dear money does reduce inflation, which, however, might be insignificant in view of the magnitude of inflation. The same holds for increases in unemployment, which increases the current account surplus and moderates wages demands. The Phillips' curve effect is significant, and does work to reduce inflation, but most likely its contribution is marginal when compared to magnitude of inflation. This is actually extensively observed as regards recent high inflations in Latin America.

Some interesting issues arise in connection with changes in øw. By revising their wage targets downwards, or by increasing øw, inflation and real exchange rates are reduced or actual real wages are increased. This means that workers could make gains by exercising restraint, which is somewhat paradoxical. The reason for this result is associated with the fact that as workers attempt to close the wage gap creating inflation, the external position is worsened for inflation generates capital outflows or "flights" from the currency. In such conditions the terms of the incompatibility between øw and øe are worsened for the latter assures external balance only at zero inflation. Under a positive inflation an even higher real exchange rate (a lower real wage) would be necessary to secure external balance. The wage push is actually self defeating, not only because the targets are not met but also because their action causes a further reduction in actual real wages. This is one of many instances in economics of an undesirable social outcome resulting from the individual actions guided by rational self interest. There is no implicit "irrationality" involved for the collective behavior of a multiplicity of individuals does not exhibit "rationality" properties as usually defined for individuals. Lastly one should consider the adjustment mechanisms implied by the arrows in Graph 5-1. Consider a point like A off the BP curve, for which the exchange rate is too high, or "undervalued", or that e/p > øe. For inflation being determined, at least momentarily, by past history, equation (4) would tell us that the (nominal) exchanges would tend to appreciate (or to depreciate more slowly). In such conditions, and for interest rates maintained constant, rt-êt increases with respect to r*t bringing capital inflows and further appreciation. That goes on until êt becomes constant (when the gap øe

- e/p is equal to (êt - Ït)/î); no further capital inflows are generated and the tendency for appreciation ceases. At point B external balance holds but the economy is off the PP curve. At B workers observe that real wages are too high, or that e/p > øw; that determines some moderation in wage demands and a deceleration in the rate of growth of nominal wages, producing a falling inflation rate and a movement towards point C. At C we would still observe e/p > øw but the existing level of inflation is such as to match the deflationary wage pressure with the inertial component of inflation. At C the economy is again off the BP curve like in A, so that the tendency will be for the economy to go towards D and eventually øe = øw will be reached. An interesting aspect of this sort of adjustment process is that the action in the "goods market" is usually assumed to take place in a slower pace; foreign exchange markets are commonly considered auction markets in which adjustment is instantaneous. This asymmetry in speeds of adjustment is quite common in the recent models of flexible exchange rate; in the context of this model the path of the economy from A towards øe =

øw would be like a "jump" to B after which the economy would reach øe = øw at zero inflation moving along the BP curve. This is an interesting possibility yet one should be careful with it in the examination of the dynamics of external shocks in the next sections; this model is a simple discrete time system in which, in principle, all the action takes place simultaneously.

5.3) External imbalances and the generation of high inflation

5.3.1) The vicious circle Adverse external shocks are assumed to take the form of increases in R in equation (3), though they could also be considered less simply as changes in ä or ß 14. Changes in R affect both BP and PP curves as shown in Graph 5-2. The external balance relation is shifted upwards (inwards), as the preexisting combination of e/p and Ï now corresponds to a payments deficit, that should be reduced by a real depreciation (an increase in e/p) and/or a reduction in inflation (expected depreciation). The PP relation is shifted outwards (downwards) because the increase in R also increases øe: a worsening of the country's long run payments position raises the long run equilibrium real exchange rate. A distributive tension is thus generated as now we have that øe > øw or that the fair wage is no longer compatible with external balance. Similar effects are produced by a decrease in øw, or an upward revision of workers fair wage, yet this would not shift the BP curve. As discussed in great detail in Chapter 3, there is strong evidence that both things, external imbalances and more ambitious wage demands, took place in the 1920s.

The effects of an adverse external shock are illustrated in Graph 5-2. Our description of the implied dynamics is actually only an approximation for in this simple

14 Changes in ä or ß would shift and rotate equation BP of Graph 5-1. Though interesting theoretically this does not add much substance to our story for external shocks and can introduce more complications. discrete time model everything happens simultaneously. The first effect is on the foreign exchange market; since under a regime of freely floating exchange rates it may be considered that the economy is always on the BP curve meaning that external "balance" always obtains at least in the sense that the market for foreign exchange always clears at some price.

e/p PP PP’ BP’

BP B

A

Ð

Ð3 ÐC

A’

C’ Wˆ

Graph 5-2: Adverse External Shock Fully Accommodated

As the economy moves from A towards B in Graph 5-2 at a much higher e/p it follows that exchange depreciation runs ahead of inflation, and inflation ahead of as indicated in the lower half of the graph. With the jump in the exchanges workers perceive that their real wages have been reduced with respect to the level corresponding to øw; they respond to this by pushing nominal wages up in a proportion to the newly created wage gap. For the mark-ups to remain constant this pressures result in an accelleration of inflation which starts to catch up with exchange rate depreciation; a higher inflation on the other hand creates capital flights and worsens the external balance requirement. But as the implied deterioration in the capital account, which is given by

ä.[á - î/è] is not as big as the improvement in the current account generated by the reduction in real wages - or that ß> ä.[á - î/è] as determined by equation (11) - a point is eventually reached in which wages are low enough to assure external balance with the increased R and with the increased inflation that workers themselves created. Workers never really recover the initial loss, much on the contrary the wage push generates more depreciation and in so doing determines a further deterioration in real wages. As shown in the lower half of the graph during the whole period of adjustment wage growth was below inflation; our stability conditions assure that wage growth accelerates more than inflation so that the spiral is dampened and an equilibrium is eventually reached for wˆ t=êt=Ït at point C'. The level of inflation at C depends on the parameters of the model or on how "tight" the condition expressed in equation (11) is met.

5.3.2) Monetary accommodation Graph 5-2 pictured the simultaneous determination of inflation and real exchange rates (real wages) for interest rates taken as given, or under the assumption of full monetary accommodation. It is interesting, in this connection, to consider explicitly the combination of this chapter's treatment of the process of determination of inflation with the hypothesis of passive money considered in the last chapter. The graphic representation of this chapter's model can be very easily combined with a variation of Graph 4-1 that pictures "total revenues", that is seigniorage plus tax revenues, considering the latter as subject to the Oliveira-Tanzi effect; this is done in Graph 5-3 below. It was strongly suggested in the last chapter that the determination of government expenditures and also of the growth of the money supply seemed to respond to inflation rather than otherwise. This process can be illustrated with the help of Graph 5-3. Consider first the equilibrium with no "incompatibilities" and zero inflation at point A in the lower half of Graph 5-3 with øw = øe. At zero inflation the total government revenues are equal to the collection of taxes or it is equal to A', so that the budget is balanced at this point. Consider now an adverse external shock, that may or may not be simultaneous with a downwards revision of øw, that generates a new equilibrium at C with a much higher rate of inflation. Consider, for the time being, that the shock is so big that the government does not regard as feasible to deny accommodation for Ïc. As inflation starts to accelerate, the economy drives to C and tax revenues start to be adversely affected. If expenditure is maintained constant at A', a budget deficit progressively develops, as shown in the upper half of Graph 5-3, untill reaching the value of d. øw = øe

G,R

B` total revenues A` d taxes

e/p

BP C 2

B BP1

A

PP1 PP2

Ðc Ð

Graph 5-3: External shocks under full accommodation

As monetary accommodation is provided the central banks start issuing new money not only to finance the budget deficit but also to satisfy the private sector's demand for money. The seigniorage created reaches the value of B', though only a portion of it is appropriated by the government. Monetary expansion then runs ahead of the government budgetary needs, as indeed observed during the hyperinflations according to the evidence provided in Chapter 4. As the government perceives that by providing unrestricted monetary accommodation the central bank generates seigniorage that the government does not use, the tendency is for government expenditure to increase in proportion to this "surplus", which would have further inflationary implications.

Graph 5-4: Contractionary monetary policies

G,R

total B` revenues A` d` d taxes

e/p

BP A 1 B BP2

C

PP2 PP 1

ÐC ÐA Ð

The effects of dear money are straightforwards, as seen in Graph 5-4. Dear money shifts BP downwards for it triggers capital inflows and shifts PP inwards for it improves the long run external constraint, or it reduces øe. These shifts are reinforced by effects of dear money on and levels of employment15. As regards the possible refusal of the monetary authorities to provide accommodation for an external shock, such as the one that drove the economy from A to C in Graph 5-3, it should be noted that at least in theory interest rates could go as high as to erase altogether the inflationary repercussions of the adverse shock. In fact, interest rates should be set in such a way as to prevent any movement of the exchange rate, or to compensate the adverse shock R in full by increased capital inflows ä. r t and by reductions in the level of employment. The feasibility of such policy choice would

15 Higher interest rates would also shift the total revenues curve downwards in the upper half of the Graph. depend on the parameter ä, the responsiveness of capital movements to differentials, and how high unemployment rates might go and obviously on the "size" of the shock. Similarly, if one thinks on the effectiveness of dear money to bring inflation from an equilibrium point all the way back to zero, the same factors would be important, though instead of the size of the shock it would matter the "size", or the level of inflation. In more general terms, however, the "existence" of such zero-inflation level of interest rate means little as far as the practical effectiveness of is concerned. Interest rates that are too high might have serious effects over the levels of employment, so that one can think of limits beyond which interest rates should not go, and also on the maximum duration of spells of dear money. In fact this brings us back to the issue of the costs of stabilization by means of monetary policy. Open economies can get more mileage out of the monetary restraint, but for high inflation this "bonus" might simply not help and besides it is not clear whether this "bonus" should not be repaid back at some point in the future. As far as the hyperinflations are concerned there are several reasons to be skeptical about the powers of dear money to produce capital inflows or the dishoarding of foreign currencies from domestic residents. In some cases, such as in Hungary and Poland, financial backwardness and low openness combined perversely to reduce the scope for monetary policy. This was not the case for Germany and Austria, though these countries, more than the other two, faced very visible risks of political and economic collapse. The hyperinflation environment was perhaps the worst possible atmosphere for the workings of a process of arbitraging rates of return. For speculators with foreign exchange there was a problem in responding to high interest rates in the inflation country in the risks involved in reconverting the capital into foreign exchange. This could be solved by purchasing foreign exchange forwards, but this possibility was available only in Germany. In the others three countries interest arbitrage was uncovered, and given that the variance of the errors in exchange depreciation forecast can be thought as proportional to the levels of depreciation, the risks involved were very high. In addition to that, even where arbitrage was "covered", investors could not hedge against errors in the inflation forecasts embodied in nominal interest rates in the inflating country, for changes in these expectations would produce changes in the prices of domestic securities that could inflict capital losses on arbitrageurs. Since the variance of inflation forecast errors was also positively related to the levels of inflation, these risks were certainly very considerable16.

5.4) A preliminary look at the evidence

The estimation of the model developed in the last sections involves equations in which inflation is explained by inertial factors, by unemployment rates and by interest rates differentials. Since there are no figures for the latter17 one alternative is to imagine the capital account as governed by the difference between domestic inflation and exchange rate depreciation, which leads to reduced forms in which interest rates do not appear. Another difficulty is that many of the parameters of the model are affected by inflation, such as and ã for example. This implies that a proper econometric estimation may involve techniques that might become very complex. We opted, however, to proceed as if these parameters were unaffected by inflation, which certainly means that better equations can be provided if these interactions are considered. As a preliminary effort the option of taking these parameters as constantsThe alternative is to estimate a structural equation corresponding to the internal "balance" segment of the model; using equations (7) and (8) one derives:

P t = mˆ t + q.l.g.P t-1 + q.l.(1- g).êt-1 + (1-q).ê t - q.s.u t + W.q.[w - (w / p) t ] (12) By rewriting equation (3) as:

ße.(e/p) + ßu.ut + ä.(Ït - êt) = R (13) it is possible to write:

êt = Ït + (1/ä).[R - ße.(e/p) + ßu.ut] (14)

16 Consider that the rate of return of a security in the inflation country is given by (r+Ïe+êe). Forward markets can eliminate exchange risks and make this equal to (r+Ïe+ê). It might be that, for instance, this expectation of inflation underpredicted inflation, so that for an unchanged real rate of interest the price of a bond reflecting this rate of return will fall to a discount inflicting a capital loss on the investor. This risk is related to the exchange risk because Ït and êt are highly correlated, yet there is an independent component that basically relates to changes in the real exchange rate. 17 For all countries there exist series for the discount rates of Central Banks, which in some cases were not altered more than half a dozen times during the whole episode. Credit rationing was extensively practiced, which can be substituted into (12) to generate an equilibrium expression for inflation in which interest rates do not appear. The equilibrium expression is:

P t = f 0 + f1.mˆ t + f2 .P t-1 + f 3.êt-1 - f 4.u t - f 5.(w / p)t (15) where: f0 = (1/ d.a1).[(1- q).R.a1 + W.yw .d.a1 -(1-q).be .a 0 ] f1 = (1/ q) f2 = (l.g) f3 = [l.(1- g)] f 4 = [s+ (1-q).bu / d f5 = [W -(1-q).be / d.a1] Equation (15) should not be estimated as it stands for there would be a problem of multicolinearity, as lagged inflation and lagged exchange depreciation are correlated, and also in view of the usual problem of residuals correlated with regressors present in regressions with lagged dependent variables. In order to eliminate this problem lagged versions of (15) can be used to substitute recursively for the lagged inflation terms, from which one gets an expression relating inflation to distributed lag versions of exchange depreciation, the real wage and the mark-up change:

2 2 P t = f0 (1+ f2 + f 2 +...) + (f1.mˆ t + f1.f2 .m t-1 + f1.f2 .m t-2...) + 2 2 + (f3 .ê t-1 + f3 .f2 .ê t-2 + .f3 .f2 .ê t-3 ...) - (f4 .u t + f4 .f2 .u t-1 + f4 .f 2.u t-2 ...) - (16) 2 - (f5 .(w/ p) t + f5 .f 2.(w / p)t-1 + f5 .f2 .(w / p) t-2 ...) In principle an equation like (16) poses no difficulty other than the large number of regressors; successive experimentation shows that the higher order terms are hardly significant so that this does not seem to be a problem. The factors governing the behavior of mark-ups are the level of capacity utilization - which is captured by the unemployment rate - and the variability of inflation. The basic idea is that increasing uncertainty about costs and demand conditions, which is produced by accelerating inflation rates, works like imputed adverse effects on costs and demand which would take the form of increases so that these rates are certainly not appropriate as expressions of the state of money market; the work done with these rates, understandably, produced questionable results. Cf. S. Webb (1984) and (1985b). in mark-ups. In this connection, mark-ups should be positively related with inflation variability, and consequently with inflation.

Table 5-1 Hyperinflation countries: Regression results for the inflation equation (t statistics in parentheses)

2 country constant êt êt-1 êt-2 (w/p)t (w/p)t-1 Ut ät R DW

1 † † † # † Germany 110.5 0.23 0.24 -0.18 -1.32 - 1.81 2.54 0.94 1.63 (4.3) (7.4) (2.8) (-2.3) (-4.3) (1.0) (1.5) † † † # † Germany 111.2 0.23 0.24 -0.17 -1.28 - - 2.60 0.94 1.62 (4.3) (7.5) (2.8) (-2.2) (-4.2) (1.5) 2 † # # Austria 78.1 0.72 -0.12 - -2.06 1.09 0.05 0.12 0.82 1.37 (0.9) (4.8) (-0.8) (-1.8) (0.8) (0.4) (2.0) Austria 120.8# 0.65† - - -1.55# - 0.13 0.11# 0.81 1.42 (2.1) (5.2) (-2.0) (1.3) (1.9) 3 † # # Hungary -11.2 0.89 -0.25 0.15 - - 0.53 0.11 0.90 1.58 (-0.8) (6.3) (-2.0) (0.8) (0.7) (2.0) † † # Hungary -11.9 0.90 -0.26 - - - 0.56 0.10 0.90 1.45 (-0.9) (8.9) (-2.5) (0.8) (2.4) Poland4 52.0 (1.2) (13.1) (2.8) -0.46# (-0.6) (-1.0) (0.0) (0.5) † † † Poland 72.2 0.63 0.13 - -0.26 - 0.96 1.96 (3.2) (14.4) (3.0) (-1.0) (-2.1) SOURCES and OBSERVATIONS: † significant at 1% # significant at 5%. Price data from J. P. Young (1925) vol. I p. 530 and vol. II pp. 322 and 349. Exchange rates figures from Table 4-2. (1) Figures for wages and unemployment from C. Bresciani-Turroni(1937) pp. 449-450, variability indexes from Z. Hercowitz(1981) p.338. The period considered was February of 1921 to July 1923. (2) Wage figures are averages from 8 categories reported in ILO(1925) pp. 85-86, unemployment figures from E. Wicker(1984) p. 11. The period considered was March 1921 to May 1923. (3) Unemployment figures from J. Vägo (1925) p.348. The period considered was June 1922 to March 1925. (4) Wage figures are averages of nine categories reported in ILO(1925) pp.115-116, unemployment figures are from E. Wicker (1984) p. 5. The period considered was March 1922 to April 1924. (5) Moving sum of absolute values of changes in inflation rates except for Germany.

Equation (16) was then estimated by ordinary least squares and the regression results are reported in Table 5-1. Real wages were considered under the assumption that Ÿw referred to 1914 levels; Austrian and Polish figures correspond to averages of several categories computed from the reports of the International Labor Office and German figures correspond to wages in the mining industry. Unfortunately there is no available data for wages in Hungary on a monthly basis. Unemployment figures correspond to unionized workers only and the inflation variability index was derived following the methodoloy developed by Blejer (1979)18. It is very important to observe that, except for Germany, the periods considered for the estimation of the regressions of Table 5-1 included observations before and after the stabilization. It is remarkable that in19 view of the dimensions of the data the model could account for the apparent discontinuity represented by the stabilization without revealing any problem of serial correlation; indeed all Durbin-Watson statistics lie on the inconclusive region or rejected serial correlation20. The estimated coefficients21 for exchange depreciation are generally positive and strongly significant except for the twice lagged term for Germany and once lagged term in Hungary. The estimated coefficents for current exchange depreciation for Austria, Hungary and Poland were much larger than the ones for lagged exchange depreciation and also much larger than their degrees of openness, which, according toTable 2-3, are respectively 0.24, 0.18 and 0.12 respectively22. This is a powerful indication of the presence of dollarization. The wage push terms present everywhere the right sign and are generally significant. Note that according to (13) the coefficients for (w/p)t should be equal to .ø , considering the values of ø as determined by one minus the observed degree of openness mentioned above, one would obtain values for of 1.54, 2.10 and 0.68 respect ively for Germany, Austria and Poland. In Germany, for instance, if real wages are only 80% of

18 According to whom the inflation variability index is defined as a five period moving sum of absolute values of changes in the rate of inflation. See M. Blejer (1979) and E. Foster (1978) for a discussion. For Germany an index for the variability of relative prices computed by Z. Hercowitz (1981) was used with similar results. 19 We did not consider the last four months of the German episode for which inflation rates reached an entirely different order of magnitude, appearing to explode. Something qualitatively different seems to happen at this point and it appears that this should be taken as the true frontier between an ordinary high inflation and an hyperinflation . 20 We did not consider the last four months of the German episode for which inflation rates reached an entirely different order of magnitude, appearing to explode. Something qualitatively different seems to happen at this point and it appears that this should be taken as the true frontier between an ordinary high inflation and an hyperinflation . 21 For simplicity the influence of inflation over and © was ignored in the econometric exercise. 22 Degrees of openness are defined as the ratio of the value of foreign trade divided by twice the value of GNP or the average of exports and imports divided by GNP from Table 3-3. the target then the wage push would add between 5% and 8% to the inflation rate every month if the gap persists; for a similar gap in Poland the wage push would result in additional 10% to 15% on the inflation rate and for Austria the results are less clear23. The unemployment coefficient is nowhere significant24 and it also appears with a positive sign which is not consistent with the usual Phillips' curve effect and seems compatible with mark-ups being negatively related to capacity utilization. The inflation variability coefficient is everywhere positive as expected though it is significant only for Hungary and Austria. These results should be seen with caution as we are estimating a structural equation and we do not have the proper instruments to correct for possibly inconsistent estimates. Another difficulty relates to the fact that the degrees of indexation ë, dollarization (1-ã) and wage push strenght are positively related with inflation; this would create non-linearities that would require substantially different methods of estimation. Yet, in order to assess the damage that could produced by this problem Chow tests separating the first and the second half of the period used for the regressions of Table 5-1 were performed. The test statistics did not indicate significant differences in the coefficients25, which could be an indication that the process of adoption of indexation had already taken place before.

5.5) Summary

This chapter's basic objective was to model what emerged from Chapter 3 as the fundamental imbalances behind these inflationary spurts in light of the results of the last chapter, namely that money most likely played a passive role in these episodes. The

23 The computation procedure is straightforward: the wage-push contribution to inflation is equal to the intercept minus .ø times the level of real wages considering the target as equal to 100. Considering the first regression for Germany, for example, it would be 110.5 minus 1.32 times 80 equaling 4.9%. For Austria the second regression appears to indicate that the wage push would cease for real wages approximately equal to 77% of pre-war levels, which might be due to poor estimates. 24 One possible explanation could be multicolinearity as (w/p) appear simultaneously with unemployment in the equations. But removing (w/p) from the equations does nothing to improve the estimates of the coefficients for the unemployment variable. chapter developed a simple model of "inertial inflation" following the more recent work of Latin American inflations of the 1980s in which the presence of significant external imbalances and a wage push in a flexible exchange rates framework could generate very high levels of inflation. Both the model itself and the econometrics could surely be subject to improvement, but the very essential point of the whole exercise was to argue for the viability of an "alternative" or a non strictly monetary explanation for the hyperinflations. This attempted rehabilitation of the "balance of payments" explanation of the hyperinflations is not seriously damaged by the simplified nature of the exercise. In fact, having performed well in such simple terms does just the opposite.

25 The test statistics were 1.06, 0.61, 1.32, and 3.02 for Poland, Germany, Austria, and Hungary; the critical value of the F statistics for all cases was around 4.5.

Chapter 6

Indexation, dollarization and stabilization

6.1) Introduction

The more recent visions of the problem of stopping inflation retrieved from the old notion that the problem was "technically simple", involving basically stopping the printing presses, but very often policy makers lacked the courage or the political support to undertake it. Today it is usually acknowledged that stabilization involves a problem of "fundamentals" and another related to the fact that, as argued by R. Dornbush1, "the question of how stabilization was achieved is not exactly the same as that of why hyperinflation occurred in the first place". The latter refers to what has been called "inertia", or inflationary "memory", namely the strong connection between current and lagged inflation. The nature of this link is rather complex, involving an often unclear mix of institutional factors, uninformed expectations, and strategic interaction. Yet, these issues seemed not to be present in the ends of the hyperinflations, and the reason is very simple: with the advance of indexation and its further degeneration into a process of dollarization there resulted that all economic decisions were engineered having the exchange rate as the unit of account. This would turn the "inertia" problem very simple: to wipe the "memory" of inflation would take simply to fix the exchange rate, which of course would be a lasting solution only if "fundamentals" were also addressed. This chapter is meant to serve as an introduction to the next four chapters focusing on specific features of each stabilization. It offers in the next section an historical account of the development of wage indexation that draws extensively from a thorough investigation conducted by the International Labor Office addressed mostly to the methods employed by workers in adjusting wages to the rapidly rising cost of living2. Some detail is provided on the political and institutional difficulties involved in the adoption of the so-called sliding scales, and how eventually dollarization appeared as a natural solution for living under

1 R. Dornbush (1985, p. 12). 2 The study's main object was Germany, but sub-studies were also provided for Austria, Poland, Hungary and the Soviet Union. ILO (1925), F. Sitzler (1924), C. Forchheimer (1924), J. Szturm de Sztrem (1924) and D. Pap (1924). very high inflation. Section 6.3 considers aacounts of the dissemination of dollarization and also offers some statistical indications in this direction. The last section explores at lenght the implications of dollarization for the dynamics of inflation in the context of the model of the last chapter and discusses the mechanism of stabilization in a dollarized economy. Section 6.4 also offers many indications of specific solutions reach in each of the stabilizations, which are studied in great detail in the next four chapters.

6.2) The adoption of indexation

All countries experiencing hyperinflations in the early twenties had never been exposed even to moderate inflations; indeed the comparatively small inflations they had experienced during the war had been considered as exceptional and transitory as the war itself. Economic institutions in these countries were thus forced to undergo very drastic and very quick changes in order to allow agents to develop the necessary defenses against inflation. Especially significant among these were the reduction in length and then virtual disappearance of nominal contracts and obligations and the spread of indexation, more and more with respect to foreign currencies, to virtually all classes of economic transactions. The following sub-sections outline the dissemination of indexation in the hyperinflation countries.

6.2.1) Austria The efforts to implement automatic systems of nominal wage readjustments in response to inflation was one of the crucial itens in the agenda of the first cabinets of the new Austrian Republic. In view of the unprecedented frequency of labor disputes and high inflation rates in Austria during 1919, a proposal for the adoption of sliding wage scales based on some hitherto inexistent official price index was introduced and discussed within a Commission of

Industrial Enquiry in the Autumn3. The Commission could reach no agreement on the methodoly for the calculation of the official price index, but it was generally agreed that indexation should be only partial. Chancellor Karl Renner had proposed to the Commission that wages should be divided into two parts, one corresponding to subsistence requirements that should be fully indexed and the other, which should represent the difference in the standard of living between several classes of workers, should remain constant, i. e. unindexed4. Most suggestions estimated that the indexed portion should be around 70% in the case of which new contracts would grant bi-monthly wage readjustments corresponding only to 70% of the actual inflation5. Unions did not object to partial indexation for it left a substantial portion of wages to be settled in free negotiation. According to a historian "this desire to avoid a freezing of the miserable wartime wages, and possible gain something from the inflation, also explains why the trade unions hesitated to accept an absolutely mechanical system which would automatically raise and reduce wages in accordance with the purchasing power of money"6. The actual practice included these principles and was complemented by schemes of rent control and food subsidies which formed an important compensation for such underindexing. Some larger unions, such as the metal workers' union and the Federation of Salaried Employees, have started computing their own price indexes to be used in their collective contracts. Some other unions settled very simple rules , such as for example , the brewery workers which in their agreements adopted the rise in the prices of flour, sugar, fat and beer as indexes, much like payments in kind in agriculture7. Only in the beginning of 1921, however, an official price index started to

3 As an effort of political compromised engineered by Prime Minister Karl Renner. Cf. C. Maier(1978) p. 51 and C. A. Gulick (1948) vol. I p. 151-52. 4 C. Forchheimer (1924) p. 31 and ILO (1925) p. 100. 5It is interesting to observe that at this juncture there was a legitimate concern from workers in establish a rigid mechanism that would wages from inflation but that would imply losses in real wages if prices started to fall. This reveals the extent to which even at this point the inflation was regarded as abnormal. Cf. C. Forchheimer(1924) p. 32, ILO(1925) p. 100, E. Marz (1948) p. 513ff, C. A. Gulick (1948) vol. I p. 152. 6 C. A. Gulick (1948) vol. I p. 152. be computed, but it did not command a wide acceptance as the principles based on which the index was computed were little understood and aroused distrust8. Later in 1921, as the Austrian inflation reached hyperinflation dimensions9 and food subsidies were entirely abandoned, the method of partial indexation was also abandoned. It was agreed that wages should fully reflect the increase in the cost of living and, as a compensation for the loss of food subsidies, a system of family allowances was introduced10. A Joint Decontrol Commission was formed in December of 1921, with equal numbers of employers and employees, and started to publish a new price index based on methods previously employed by some of the larger unions, which immediately enjoyed wide acceptance. Shortly after, all the larger unions signed collective contracts with sliding scales clauses based on the new index, and the smaller unions and the state official quickly followed. In the spring of 1922 the system of sliding scales had become a general rule for collective contracts in most industries11. It is difficult to establish the actual coverage of the sliding scales contracts without data on specific union membership. The metal workers union is recognized as the most important and the most active union, the "strategists of the entire Austrian trade union movement", according to Edward Marz, and most other unions followed them in their agreements12. This obviously reflected the relative importance of the several sectors of the Austrian economy. In 1920 the engineering and metal industries employed around 190.000 workers or 21.4% of the workforce in industry, commerce and transportation13. In 1925 around 10% of a total industrial population of 1.200.000 workers was of clerical workers, which formed the core of the Federation of Salaried Employees membership, and only

7 C. Forchheimer(1924) p. 35. 8 The index was computed out of a variable, and workers deemed it arbitrary, list of items assembled as to make the selection of commodities conforms with the principle that an adult male needs 3000 calories per day. Cf. C. Forchheimer(1924) p. 35, ILO(1925) p. 98 and E. Marz(1948) p.513. 9 According to P. Cagan's criteria of a 50% monthly inflation rate , the Austrian hyperinflation started in October of 1921. Cf. P. Cagan(1956) p. 26. 10 C. Forchheimer(1924) p. 38 and ILO (1925) p. 105. 11 C. Forchheimer(1924) p. 40 and ILO (1925) p. 101. 12 E. Marz(1948) p. 510. 13 W.T. Layton & C. Rist (1925) p. 50 11% of this total was not bound by some collective agreement14. In the latter part of 1922, with the attainment of the currency stabilization, a concern grew out of the need for an appropriate consideration of the "conditions of the industry" in granting wage readjusments. With the stabilization unemployment grew to alarming figures, from a total of 57.000 in October of 1922 to 167.000 in February of 1923, which allowed for some deceleration in the sharp recovery of real wages observed since June. But starting in March of 1923 the Joint Commission index again started to show some significant inflation rates15 and this considerably strengthened the workers reliance on sliding scales which thus had their existence considerably extended after the stabilization. Only in November of 1923 the metal workers would sign a collective contract without sliding scales clauses, on which they were followed by the chemical industry in December. Salaried employees, however, retained indexation provisions in case of resumption of inflation. The textiles industry, for example, signed a contract in January of 1924 establishing automatic adjustments if monthly inflation rates were more than 5%, and the building industries in December of 1923 signed a similar contract though considering a 4% monthly inflation limit. Other unions, such as bank clerks for example, retained full sliding scales as late as in January of 192416.

6.2.2) Hungary The introduction of wage indexation in Hungary was much more "informal", the main reasons being the agricultural character of the country. Hungary had 55.8% of its population in 1920 in agriculture in contrast to 37% in Austria, and 30.1% of its population in industry, commerce and transportation and 4.7% in liberal professions and public offices, while Austria had 46.5% and

14 Ibid. p. 51. 15 Monthly inflation rates, according to the Joint Commission index, were of 1% and 2% in January and February, but in the next three months reached 6%, 7% and 5%. Cf. C. Forchheimer(1924) p. 41. 16 C. Forchheimer(1924) pp. 42-44. The textiles industry, together with clothing and shoemaking employed 16.7% , and the building industry 15.9% of the total workforce in industry, commerce and transportation in Austria of 1920. Cf. W. T. Layton & C. Rist (1925) p. 50. 16.5% respectively17. There is little statistical information on agricultural wages but the available accounts emphasize the absolute predominance of wages in kind, which are said to have provided a very effective shelter from inflation18. The backwards Hungarian agriculture still accommodated a substantial contingent of farm servants under a variety of share-cropping arrangements, i. e. basically earning their income in kind19. But even for casual labourers in agricultural the legislation was especially favorable in this respect for it offered the option to the worker to have at least a substantial part of his wage paid in kind20. As long as industry was concerned one distinguishing feature of Hungarian labor relations was the scanty development of mechanisms of collective negotiation directly associated to the strong right-wing regime following the communist experiment and the resulting violence and persecution on existing unions. Most large scale industries, in contrast to smaller handicraft sectors, systematically refused to engage into collective negotiations, though in many cases a system of informal consultations was established and amounted to a de facto bargaining21. No official price index was compiled and where indexed contracts were signed one or a combination of the three available private price indexes was used. The government did not take any interest in providing for an index and neither sponsored any initiatives to establish a modern system of labor relations with collective agreements and arbitration courts. In the beginning of 1922 not even a proposal for a joint industrial entity could not be worked out as "the political conditions for collaboration between employers and workers on an equal footing did not exist"22. This represented a marked contrast with European tendencies in industrial relations, a contrast that would ultimately be reflected on

17 Austrian figures are for 1922 from E. Marz (1948) p. 272 and Hungarian figures from Republic of Hungary (1922) p.16. 18 D. Pap(1924) p.166. An interesting example along this lines is provided by Soviet Russia where government officials emphasized that inflation in their country differed from the others in that it was an instrument to expropriate the capitalists while elsewhere it served to enrich them. It followed that the government systematically attempted to protect real wages mostly by payments in kind. It is recorded that in 1919 64% of all wage payments were made in kind , and this share increased to 84% in 1920 and to 93% in the first quarter of 1921. Cf. L.Yeager(1981) p. 73. 19 I. T. Berend & G. Ránki (1974b) pp. 154-155. 20 D. Pap (1923) pp. 649-653. 21 D. Pap (1924) p.166. the standard of living of the working classes throughout the 1920s. Again in 1923, with inflation in full swing, unions pressured the government to establish compulsory sliding-scales and arbitration courts, to which the government reacted by obtaining emergency powers to issue orders on labor disputes. But in any event, despite the strong resistance to introduce formal mechanisms of indexation "owing to the greater clearness of ideas on the subject and also to the tenacious struggles of the workers, considerable progress has been made in taking the rise in prices into account in fixing wages", and in 1923 indexed contracts were "again introduced, and today [February of 1925] it is already fairly widespread, though not so much in large scale industry as in handicraft"23.

6.2.3) Poland The introduction of sliding scales clauses in collective contracts in Poland had a decisive impulse in May of 1920 when the government appointed a joint commission to investigate the "Increases of the Cost of Living for Families of Workers Engaged in Industry and Commerce". This commission was attached to the Central Statistical Office and was composed of equal numbers of representatives from the unions, employers and government. Their function was to produce an official cost of living index based on prices collected in several municipalities and with allowance for the marked regional differences in prices among the several parts of the country. The lack of such index introduced considerable difficulties in the negotiations of collective contracts, which were very disseminated in Poland, even in agriculture. The earliest application of sliding scales clauses was in a contract for the wood industry in June of 1920, which was followed by contracts for the tobacco, metal-working and chemical industries, chemists' shops and municipal telephone services still in 192024. Out of 165 collective contracts registered in 1920 and

22 Ibid. p. 158. 23 Ibid. p. 161. 24 J. Szturm de Sztrem (1924) p. 400. In 1937 the wood , metal-working and chemical industries employed around 278 thousand workers out of a total industrial labor force estimated at 730 1921, 45 included sliding scales clauses, and these referred mostly to the largest industrial sectors where unions were more active and represented a substantial part of the industrial labor force25. The index of the joint commission was generally considered very reliable, which rendered it very popular26, and as inflation persisted and accelerated after June of 1922 the use of sliding scales quickly became general, with resistances being found only in small undertakings, offices, domestic servants and also for government officials27. The latter, which included some half a million workers, constituted a case of very late adoption of sliding scales, which they managed to include only in their contract of February of 192328. Collective contracts had been made compulsory in agriculture, where 60% of the labor force effectively worked29. Part of the wage was traditionally paid in kind and contracts usually indexed the part in cash to the average price of some agricultural produce30. In 1922 a large collective contract concluded for the first time for a group of seven central and western provinces established that wages were to be fixed in rye and reckoned in marks every quarter according to the average market prices of rye observed31. The collective contracts employed in Poland at this time usually established monthly adjustments on the basis of the observed inflation in the previous month, which worked smoothly during 1921 and part of 1922. But this method tended to produce significant losses if inflation was accelerating so that, as hyperinflation started a number of "compensations" were introduced. A common expedient was a special ad-hoc bonus paid every time there was a substantial difference between the rates of inflation for the current and previous month. In the autumn of 1923, for example, state officials demanded a bonus equivalent to two months of salary, and the government had to concede most of

thousand. Cf. J. Taylor(1953) p. 84. 25 J. Szturm de Sztrem (1922) pp. 1-2. 26 ILO (1925) p. 123. 27 Ibid. p. 124 and J. Szturm de Sztrem (1924) p. 400. 28 Ibid. idem . 29 Z. Landau & J. Tomaszewski (1985) p. 56. 30 ILO (1925) p. 124 ff. 31 Republic of Poland (1928) p. 45. it32. In other cases the adjustment was made quicker, or on the basis of the inflation rates of the last week of the previous month, and in some others wages fixed in gold started to be adopted. But in general these methods could not avoid a substantial fall in real wages during the period of higher inflation33. Late in the inflation process the government passed a law making compulsory the introduction of sliding scales in all collective contracts, at least until the real wages of the workers in question did not reach the levels of June of 191434. Meanwhile, wages established in zloty or gold and paid in marks at current rates of exchange were increasingly used as the currency as stabilized. At this point sliding scale in industry were firmly established and continued to be employed at least until the spring of 1924. Thereafter, the increased unemployment and the fact that wages recovered their pre-war levels, thus making workers loose the support of the law, led to their gradual abandonment35. In agriculture, however, the system of reckoning wages in rye and paying them in currency according to the average market prices persisted untouched at least until 192836.

6.2.4) Germany The development of wage indexation in Germany took place within a well established and widely accepted system of collective agreements covering an estimated 14 million workers, or 84% of the total labor force in agriculture, industry and commerce37. Collective contracts adapted to the inflationary environment in two principal ways: first, the wage provisions started to be drawn independently of the rest of the contract, considerably speeding the process of collective bargaining38; and second, the period covered by these wage clauses was progressively curtailed. Before the war contracts and its respective wage

32 ILO (1925) p. 124. 33 Ibid. p. 115 and Z. Landau (1968) p. 199. 34 ILO (1925) p. 126. 35 Ibid. p. 127. 36 Republic of Poland (1928) pp. 45, 58 37 ILO (1925) pp. 44-45. C. Bresciani-Turroni(1929) argues further that this represented 75% of the total working population. 38 ILO (1925) p. 46 and F. Sitzler (1924) p. 646. provisions usually lasted one year. In the beginning of 1921 this was reduced to an average of six months and by the end of the year it was reduced further to an average from one to three months; late in 1922 recontracting of wage provisions was seldom concluded for more than a week or a fortnight39. In the very latest stages of the process, there are accounts of wages being recontracted and paid every day; collective bargaining was then described as "continuous"40. The spread of indexation was hampered, at least initially , by the fact that there was no reliable official cost of living index at the onset of the hyperinflation, as also observed in the other countries. This turned out to be a very problematic institutional development: an official cost of living indexes was only introduced as late as February of 1920 in Germany. Before this, labor negotiations were conducted with the help of a multiplicity of private indexes computed by federations, specific industries, unions and local authorities, and very often the discussion on the methodology for the construction of the index was confused with the very issues of wage bargaining under discussion. The official indexes were revised and improved in a number of ways before they gained wide acceptance in sliding scales agreements41. Along the way underindexing was often present and in view of this workers were compensated with a number of ad- hoc measures such as schemes for rent control, direct food subsidies and cost of living bonuses and family allowances42. The introduction of wage indexation in agriculture proved much easier than in industry. Sliding scales for agricultural wages were "widely adopted at least in those cases where the money wage was secondary to the wage in kind"43. The choice of index or basket of goods to which to index to was also much simpler for agricultural workers. In Pomerania and other agricultural districts, for example, the price of rye, often combined with that of potatoes, was generally used for indexing wage payments44. This was actually equivalent to the payment

39 Ibid. and also G. Bry (1960) p. 224. 40 G. Bry (1960) p. 225. 41 F. Sitzler (1924). 42 ILO(1925) pp. 48-53, 95-96 and 121. 43 F. Sitzler (1924) p. 650. 44 Ibid. p. 650 ff. in kind that was already in use in these districts. In any event, the flexibility thus displayed by the mechanism of free negotiation in Germany rendered unnecessary the introduction of government sponsored sliding-scales, as in Austria and Poland in analogous circumstances45. The German Ministry of Labor made every effort to improve and speed the dynamics of free collective negotiations and often expressed its disapproval of what it deemed as a "purely mechanical adaptation of wages". The Ministry of Labor's justifications for the dislike of sliding-scales - in addition to the fact that "such a system leaves no scope for making the necessary allowances for the special conditions of each branch of industry and for the general economic situation" and that it would be inflationary46 - relied on the interesting point that "wages at a given moment cannot be accepted a priori as correct, either in absolute value or in relation to one another, and should not be perpetuated by an automatic system of adaptation"47. But in mid 1923 the inflation rate became so high that it became no longer practicable to draw nominal contracts for however short a period of time. The Ministry of Labor then proposed the introduction of the so called "gold wage" system; shortly thereafter a wide agreement between employers and workers established an improved version of the government's proposal, a system of gold indexed contracts for a period ranging from 4 to 8 weeks48. As reported by an observer, "gold wages were introduced comparatively quickly and smoothly as the value of the mark became stabilized. The change began in the large towns, which were the first to have fairly large quantities of stable currencies at their disposal, and in December 1923 it spread over to the whole country "49.

45 See J. Sztrurm de Sztrem (1924) and C. Forchheimer (1924). 46 On which a report of the Ministry of Finance of September 1922 laid special emphasis. Cf. F. Sitzler (1924) p. 649. 47 Ibid. idem (our emphasis). 48 The government's proposal took the form of a publication called "P determining factor for setting prices". Cf. F. Ringer (1969) p. 80 and G. Stolper, The German Economy, p.152. Many such accounts can be found in W. Guttman & P. Meehan (1975). 49 F. Sitzler(1924) p. 659. It should also be mentioned that the acceleration of inflation gave birth to a number of practices that "substituted" for indexation such as payments in installments in advance, wages partly in kind and personal privileges such as access to food, clothing and coal at the job. Cf. G.Bry (1960) pp. 224-225.

6.3) Dollarization and Monetary Innovation

In his insightful paper on the German inflation Gerald Merkin observed that inflation manifests itself to individual agents as "a rise in costs" - higher raw materials/wages cost for firms and a higher cost of living for workers - to which agents respond by "raising one's own price". Merkin further observed that such readjustment of prices should be made according to "replacement costs", and not to "historical costs", and that "there comes a time in a period of rapid inflation when it is no longer possible to use the price index with any precision for this purpose, and therefore the calculation of the replacement price is made by reference to the current exchange rate to the dollar"50. It is interesting in this respect to quote at some length contemporary expert account of the pricing rules observed during the hyperinflation in Austria:

[in such inflationary environment] the cost price is no longer a trustworthy basis for the calculation of selling prices. In order to determine the price at which the goods must be sold so as not to incur a loss at the new price level, it is not the cost price but the actual costs of reproduction of the finished article which have to be calculated .... As regards a considerable part of the costs a basis existed in the rates of foreign exchange, for the wholesale prices of imported raw materials and coal moved up and down in unison with the rates of exchange. It should be borne in mind that Austrian industries have to import most of their raw materials and coal from abroad. The next step was therefore to estimate the cost of reproduction in some stable currency and to add a certain margin of profit. In Austria this process was called valorisieren , and the Swiss franc was generally used for the purpose. By converting the resulting figures into Austrian crowns at the rate of the exchange of the day, it was easy to say what selling price ought to be asked. Often this conversion was not even carried out: wholesale business, for instance, was transacted directly in Swiss francs .... Once the retail dealers had perceived that the wholesale prices of the articles in which they dealt rose in the same proportion as the rates of foreign exchange they also began to "valorize" their prices. In many shops the articles were marked with basic prices in dollars or Swiss francs, which were daily converted into crowns at the current rate of exchange, and thus the retail prices also began gradually to follow the rise of the foreign exchanges. The foreign exchange rates were the only fixed standard in the shifting chaos of values, and all prices adapted themselves to its measure .... the connection between the individual prices had become so firm by 1922 that not only the wholesale prices of imported goods but also the other wholesale prices, retail prices and wages rose in the same proportion as the rates of foreign exchange51.

50 Ibid. p. 43 . See also G. Bry (1960) p. 224 and ILO (1925) p. 74. 51 Emphasis in the original. Cf. J. van Walré de Bordes(1924)pp.176-178. The author, a Dutch economist and financial expert, was a member of the League's Commisioner-General's four members staff for the Austrian scheme.

In Germany, according to Schacht, "sliding, in lieu of fixed, prices for commodities became the rule before the year 1922 was out. They were arrived at either by the addition of some "supplements" calculated on the basis of the exchange quotations of foreign currencies, or by multiplication by some coefficient based on index numbers, or by any other method calculated to ensue something like stability of value ... Where prices were still quoted in marks, they were revised at ever shorter intervals"52. Bresciani-Turroni reports that "in the summer of 1922 .... the most important industries, one after another, adopted the practice of expressing prices in a foreign "appreciated" money (dollars, Swiss francs, Dutch florins, etc.) or in gold marks"53. In Poland, especially after the introduction of the zloty in the summer of 1923, the practice of expressing prices in dollars became general; according to a contemporary, the Polish mark was "virtually abandoned as a monetary standard; all calculations were effected in stable currencies. Prices followed rigorously the depreciation of the mark in the exchange market or even surpassed it in view of the habit developed during the inflation of fixing them including a premium so as to insure against the sudden depreciation of the currency"54. The advance of dollarization can be otherwise attested by a different methodology. Table 6-1 shows correlations between inflation and lagged inflation and exchange depreciation during the hyperinflations:

52 H. Schacht (1927) p. 66. 53 C. Bresciani-Turroni (1937) p. 342. According to Angell in 1923 "the depreciation became so rapid that prices in many shops were adjusted to the exchange rates every hour or two, and eventually were fixed outright in foreign currencies". Cf. J. Angell (1932) p. 22. "All the stores, according to an observer , close at noon until the new exchange rate is published". Cf. Karl-Heinz Abshagen reproduced in H. C. Meyer (1973) p.129. Eventually, "the dollar ...became the yardstick of values and the determining factor for setting prices". Cf. F. Ringer(1969) p. 80 and G. Stolper (1940) p.152. Many such accounts can be found in W. Guttman & P. Meehan(1975). 54 P. Robin (1932) p. 17. See also M. A. Heilperin (1931) p. 94, Z. Landau(1983) p. 515, L. Czarnozyl (1930) p. 71 and G. Zdziechowski (1925) p. 4. For similar accounts for Hungary see Table 6-1 Correlations Between Inflation, Lagged Inflation and Exchange Depreciation1

Austria Hungary Germany Poland

Ðt-1 êt-1 Ðt-1 êt-1 Ðt-1 êt-1 Ðt-1 êt-1 First 0.51 0.73 0.46 0.55 0.18 0.74 0.30 0.14 Half3 Second 0.54 0.93 -0.16 0.92 0.36 0.98 0.44 0.93 Half Whole 0.57 0.83 0.39 0.69 0.37 0.98 0.55 0.85 Period2 SOURCES and OBSERVATIONS: (1) Sources of price data are the same of Table 5-1, and for exchange rates Table 4-2. (2) periods considered were January 1921 to August 1923 for Germany, February 1921 to November of 1922 for Austria, May 1921 to April 1924 for Poland and January of 1921 to June of 1924 for Hungary. (3) Included 16 observations for Germany, 11 for Austria, 15 for Poland and 22 for Hungary.

The idea underlying Table 6-1 is that the advance of dollarization would lead to an increasing correlation between current inflation and the lagged value of the exchange rates depreciation55. This can seen by computing and comparing correlations for the "early" hyperinflation period - the first half - vis-à-vis the "late" period, or the second half. Table 6-1 considered periods considerably longer, whenever possible, than Cagan's hyperinflation period as delimited by his definition of hyperinflation. The correlations between inflation and exchange depreciation were already high during the first half of the period, except for Poland, which would be consistent to the fact that some indexation with respect to exchange rates or gold units of account (pre-war gold marks or gold crowns) was already being implemented. For the second half all correlations between inflation and depreciation reached very high values, which is fully compatible with the evidence of widespread indexation with respect to the exchange rates. It is interesting to observe that the correlations between current and lagged inflation were not especially high during the first period, much in the contrary for Germany, and increased only slightly on the second half, even declining up to a

M. Mitzakis (1925) pp. 112,120,164 and 173. 55 For Poland and Germany we used exchange rates that were monthly averages so that the depreciation thus calculated would be like a "half-lagged" value with respect to depreciation as computed with observations of end of the month exchange rates ; in these cases the correlations computed in Table 2-2 are referred to "current" exchange rate depreciation . negative correlation in Hungary. This is due to the fact that exchange rates were generally used for indexing purposes, as opposed to lagged observations of the price indexes.

6.4) The making of stabilizations: an outline

The problem of inflation stabilization, as usually presented, comprises a problem of "fundamentals" and another related to the fact that, as argued by R. Dornbush56, "the question of how stabilization was achieved is not exactly the same as that of why hyperinflation occurred in the first place". Ordinarily, in order to remove the link between current and lagged inflation - which is likely to be very strong in low or intermediary inflations - the public faces a problem of collective decision making that involves a complex "intra-public" game similar to the one involved in the provision of a - price stability in this case - and that involves strong incentives to free-riders. The problem of wiping out this "inflationary memory" are being recurrently emphasized in the debates around the stabilizations of high inflations of our days57 and different attempts to provide solutions are embodied in some of the "heterodox" packages applied in Brazil, Israel, Argentina and Mexico. The inertia problem, however, was hardly an issue in the cases of the hyperinflations of the 1920s (and also for the recent Bolivian case!) basically because the "coordination" problem was sidelined by the phenomenon of dollarization. Since every price in the economy was quoted in dollars, and transactions were made using the exchange rates of the day (of the hour !), pegging the exchange rate was all that was necessary to stop inflation overnight. This was actually the reason why the hyperinflations ended so abruptly58. It is easy to see this in the framework of Chapter 5's model, in which inflation is determined by inflationary inertia and by "fundamentals" which

56 R. Dornbush (1985, p. 12). 57 On the absolute need of coordination devices ("incomes policies" in their terminology) to fight high inflations see R. Dornbush & M. H. Simonsen (1987). 58 This fundamental point has escaped the attention of most writers on the subject; significant correspond to the inconsistency between ye and y w . This is easily seen by rewriting the internal balance - or the dynamics of inflation - relation: P = l.{(1- g).P + g.ê }+ a .W.{(e / p) - y }+ t t-1 t-1 1 t w (1) + q´.x.{y e - (e/ p)t }-s(u t ) Note that even if it is possible to wipe out inertia - the first term in the equation - this would not be sufficient in itself as a stabilization strategy, once it provides no a solution for the fundamental problem of the incompatibility between ye and y w . In this connection "artificial" stabilizations obtained by price freezes, economy wide agreements, or temporary fixing of the exchange rate are likely to collapse if ye and y w are not reconciled; similarly the solution for the distributive tension in itself would not do away with the system's inflationary memory. The process of dollarization would bring two important implications to the dynamics of inflation as described by equation (1) that would play a very important role in solving the inertia problem. The first is to consider that as contract length had become very small, the lagged effect of the exchange depreciation on prices due to wages indexed to gold, or other forms of indexation, becomes nearly indistinguishable from the current effect especially if one is working with monthly data. This allows us to rewrite the wage indexation relation as59:

wˆ t = l.{g.P t-1 + (1- g).ê t}+ W.{y w - (w/ p) t}- s(u t ) (2) The second important effect of the advance of dollarization is that g ® 0 , which means that the term on Ðt-1 or inflationary inertia progressively disappears. Yet dollarization in itself does not imply a reduction in inflation for the system remains in an equilibrium very close to the one under no dollarization60. In the

exceptions are G. Merkin (1982), F. L. Lopes (1986) and G. H. B. Franco (1987). 59 Under this assumption the PP relation would be slightly different, and its slope would now includes ë and ã explicitly so that the stability conditions would now be related with the degrees of indexation and dollarization. Again stability implies that the slope of PP to be greater than the slope of BP, which is more likely to be violated when the degree of indexation increases. Yet it is significant that the model becomes unstable for some ë<1, for we do not actually need the PP curve to be flat but only to be steeper than BP. 60 Comparing the implied expressions for the PP relation under ã = 0 and ã =1 it can be shown that equilibrium the level of inflation is precisely the factor that is enlarging the external imbalance to a point that wages have to be considerably reduced to assure external balance; the current account is thus adjusting to effect the "transfer" of the capital flights. The reaction of workers to the pressure to reduce wages, meaning partial indexation and a wage push term, is precisely what maintain inflation so the cycle is closed. Along the way, the original impulse, namely ye - y w , might have become small as compared to the levels of inflation. The distinctive characteristic of a dollarized economy is that inflation can be written very simply as:

P t = [1-q(1- l)].êt + q.W.{w - (w/ p) t}-s(u t ) (3)

Since êt is mostly determined by inflation itself, equation (3) describes a vicious circle whose "height" may have gotten entirely out of proportion with the original impulse q.W.{w -(w / p)t }. Inflation is then overwhelmingly determined by exchange depreciation, as it is indeed observed in the regressions of the last chapter, so that the obvious and natural way to cut the inflationary process back to the size of the real wage gap in one stroke in a dollarized economy is to fix the exchange rate61. All four hyperinflations were terminated this way, and following the stabilization in most cases a moderate wage driven inflation ensued until the wage gap, which had reached very large values at the peaks of the hyperinflations, was closed as shown in great detail in chapters 8, 9 and 10. The mechanisms involved in such stabilizations can be seen with the help of Graph 6-1.

the intercept is increased (or the PP shifts upwards) and the slope is decreased (or the curve rotates outwards) so that the final result as far as equilibrium inflation is concerned is ambiguous. In fact inflation would be slightly higher as the economy dollarizes if the level of inflation is high. 61 For economies that are not dollarized and not very open fixing the exchange rate might be quite ineffective to terminate inflation, as it is clearly demonstrated by repeated experiences in Latin America and especially in Argentina.

e/p PP

BP

_ B e / p A øe

øw C

Ð Graph 6-1: Pegging exchange rates under full dollarization

Consider a dollarized economy, at least in the sense that equation (3) holds, that is in an equilibrium at point A in Graph 6-1. As the central bank fixes the exchange rate at the current market rate, or at e , inflation is brought immediately to zero at point B, for stopping exchange depreciation is immediately transmitted to prices by the dollarization mechanism. At this point, however, the real exchange rate is greater thanye , or the economy is on a surplus region accumulating reserves. That happens because without inflation capital outflows or "flights" from the currency should cease. The issue at this point is obviously how reliable is the stabilization so that most likely confidence (or the lack thereof) might be such that the BP curve might be very flat at this point. At B, on the other hand, wages are much lower than the target level so that a wage push quickly ensues. The inflation thus generated gradually erodes the real exchange rate bringing the economy from the surplus to the deficit region, i. e. crossing the BP curve, until point C is reached. At C point the wage pressure ceases because real wages have reached the target but since the basic incompatibility between y w and ye is not solved at point C the economy is experiencing a payments deficit which is basically financed by running out of reserves. It is clear though that under fixed exchange rates the economy tends to settle at y w , or where the wage target is met. If ye y w this would be a deficit region and at some point in the future the peg might have to be suspended. Dear money can help to reduce the gap, and thus the outflow of reserves for it could bring the two curves closer together. In fact, experience shows that for "moderate" imbalances dear money can be maintained for prolonged periods of time; Britain after 1925 provides a benchmark example in this respect. But for the four countries considered with it is fair to say that the inconsistency between y w

62 and ye could not be solved unless temporarily or marginally by dear money .

The crucial part of the process is the reconciliation between y w and ye or a solution for the "fundamentals" of the problem. In fact the only possible long run equilibrium under fixed exchange rates would obtain when y w = ye , i. e. without wage push inflation and without pressure over reserves, where external balance obtains at the target wage. The stock of international reserves plays a very important role in the process for even under a significant inconsistency between y w and ye a large stock of reserves could "buy time" which in practice might result very important for the end of the hyperinflations. Normally the economy will take some time, or successive strokes of the wage push, to go from B to C in Graph 6-1, and once there the stock of reserves would determine how long the peg can be sustained. By sustaining the peg for a long time the government might achieve many things. Tax revenues, for instance, recover dramatically and the economy approaches budgetary balance. This and the success of the government intervention in the foreign exchange market might build up "confidence", which might be translated into autonomous capital inflows (a decrease in R). In addition to that a prolonged period of price stability would dissolve indexation arrangements, which might become very important if for some reason the government is forced to abandon

62 After all, if contractionary policies are able to produce significant shifts in both schedules, then we are assuming that inflation is low enough to be affected by purgative , and this is not appropriate for high inflations. the peg and let the currency float. The choice of parity is also important as far as "buying time" is concerned. By choosing to stabilize at the market rate, as assumed in Graph 6-1, the government gain the time required for the economy to cross the BP curve and enter the deficit region and also the time it takes to reach y w . If the government is not interested in experiencing that inflationary spell it could stabilize, for instance, at y w . The path from B to C is abbreviated but from the very beginning the economy is in the deficit region so that relatively to stabilizing at the market rate the y w alternative requires more reserves to sustain the peg for the same period of time. It might very well be that there are no reserves enough to secure a choice like y w . Thus by choosing a high (a more depreciated) parity the policy authority will commit less reserves at first but will inevitably face inflationary pressures originating on the wage push sometime later. This is a fair description of the Polish case, as we will see in detail in Chapter 9. By choosing y w initially the policy authority could avoid this inflationary episode by determining a large one-shot appreciation of the currency; this is very much what happened in Germany, as we will see in Chapter 10. In this case a substantially larger amount of reserves and/or contractionary policies might be required. Regardless of the stock of international reserves the fundamental condition for the stabilization was the reconciliation of y w and ye . All four countries experienced a major improvement in their international position either during the inflation period (by gains of territory or by forced "revisions" in wage targets induced by an authoritarian government, for example) or after the stabilization (for example, by regained access to international capital markets or by a major rescheduling of external debts). The second half of the 1920s was a period of abundance in terms of foreign capital so that to a great extent these countries imbalances, or the difference between ye and y w , could be solved by autonomous capital inflows (a reduction in R enough to equate ye and y w ). In

each case, however, this solution would acquire specific character. For Austria and Hungary, for instance, the stabilization implied, as predicted in our model, a sharp increase in real wages towards pre-war levels63, as it will be seen in detail in Chapter 8. The respective budgets would be very quickly balanced, as we will see in the next chapter, mostly by the autonomous recovery of the revenues. Large external loans were floated for both countries, and such loans by themselves were large enough to sustain the peg in both cases for a very considerable period of time. But apart from the loans themselves a steady inflow of long term capital was reestablished, Vienna regained her role as trading center connecting Eastern and Western Europe, an array of commercial treaties was promoted under the League's auspices and markedly contractionary policies, fiscal and monetary, were also implemented. For Hungary more specifically, the recovery of wages was only moderate and the average unemployment rates for the few years following the stabilization was much higher than elsewhere. This could be so as the authoritarian government that ruled the country throughout the 1920s destroyed union organization and forced a downwards "revision" of the wage demands. In Germany the stabilization would also bring wages back to their pre-war levels very quickly as the government opted for a parity rate much below (or more appreciated) than market rates. On the fiscal side, tax revenues would recover so strongly as to balance the budget in less than 40 days render superfluous any significant effort of austerity as regards expenditure. The "fundamental" solution for the inconsistency between ye and y w would come only sometime later with the rescheduling of reparations payments determined by the Dawes loan and the flood of foreign loans that followed. In the meantime Germany maintained the peg on the exchanges thanks to the by mostly by virtue of the rentenmark experiment. The introduction of the rentenmark was like a "fiduciary" increase in international reserves: being "stable-valued" the new currency satisfied in part the demand for dollars that was created by fixing the exchange rate. It was basically

63 This was somewhat deterred in Hungary by the authoritarian government policies as regards labor unions, as examined in Chapter 2. like a large external loan providing reserves for the intervention effort. The question of why the rentenmark was accepted as a stable value currency is certainly the key to the German solution to the hyperinflation problem and it will be seen in great detail in Chapter 10. The Polish stabilization followed a somewhat more complex sequence. First the government was forced to fix a parity that was somewhat above market values, so that it did not take much reserves to sustain. The Poles did not count very much on external loans, and neither did they attempted any monetary innovation such as the rentenmark, so that they did not have much alternative other than to stabilize at the market rate. The hyperinflation was successfully stopped, but after the stabilization real wages increased very fast and the initial accumulation of reserves weakened and then turned into a precipitous fall. The currency was then allowed to float but only well over one year of price stability. At this point the country's balance had been "fundamentally" improved by the annexation of Upper Silesia and by the investment projects undertaken after 1921; in addition to that indexation arrangements had been mostly dropped. At this point the Polish managed to stabilize again but at this time with contractionary policies and major changes in commercial policy. This time the Poles could go to international capital markets after having stopped the hyperinflation without external help and obtain a large stabilization loan in good conditions and with low conditionality.

6.4) Summary

This chapter provided evidence on the dissemination of indexation arrangements in labor contracts and on the advance of dollarization in the hyperinflation countries. It was then argued that dollarization modified very substantially the nature of the stabilization problem these countries faced. The "inertia" problem was then sidelined there remaining the issue of sustaining the exchange rate fixed while "fundamentals" were solved. The model developed in the last chapter was used to illustrate the mechanism of stabilization and several indications were provided on the specific features of each stabilization. The essential point to retain was that the end of the hyperinflations involved many elements: the coordination device provided by dollarization, and the resolution of issues related to "fundamentals": a substantial improvement in the external position - which might be the revision of the reparations schedule, a territorial change (as the annexation of the coal exporting Upper Silesia region to Poland) or the reopening of international capital markets - and certainly budget balance. None of these was sufficient by itself; the stabilizations succeeded only when these pieces fit together, as it will be seen in great detail in chapters 8, 9 and 10.

Chapter 7

Fiscal “reforms” and stabilizations

7.1) Introduction

Most accounts, old and new, of the end of the European hyperinflations of the 1920s attribute a key role to "fiscal reforms" implemented more or less simultaneously with the stabilizations1. Surprisingly, however, there has been little effort in detailing the nature and contents of these reforms. It is often emphasized that budgets were balanced very quickly after price stability has been achieved, but this fact in itself is not actually sufficient to establish that these reforms effectively took place. It is now recognized that inflation affects budget deficits in various respects, one of which the so called Oliveira- Tanzi effect, i. e. the fact that tax revenues are negatively affected by inflation2. Although on theoretical or a priori grounds the effects of inflation on the real value of tax revenues is said to be undetermined3, a solid body of empirical research has been built providing evidence on negative effects of inflation over the real value of tax revenues in countries experiencing high inflations4. There are many indications of the importance of the Oliveira-Tanzi effect in the hyperinflation countries5, so that it could be conjectured that the influence of price stability on deficits might very well have been an important part of the explanation for the sudden budgetary improvements observed after the end of the these hyperinflations. This chapter attempts to assess the extent of this possibility, which actually amounts to form a judgment on the "change in the fiscal regime", or the rational expectations explanations for these stabilizations. This chapter's basic contention is that the presence of such fiscal "reforms" can be seriously disputed, once evidence is provided on the nature of fiscal measures undertaken along with stabilizations. It is shown, for instance, that reductions in expenditure played a minor role in balancing these countries budget, where this was achieved, the main contribution to budgetary improvement stemming from significant increases in tax

1 Most notably the recent views of T. Sargent(1982) and C. L. Holtfferich (1985). 2 The classic case is Argentina, and the most usual references are V. Tanzi (1978 and 1977) and J. H. G. Oliveira (1967). The phenomenon is attributed most usually to lags between the fact that originates the tax and the effective collection of these taxes. 3 L. H. Summers (1981) p. 191 and M. Friedman (1974) pp. 14-15. 4 See V. Tanzi (1977 and 1978); V. Tanzi et al. (1987) B. B. Aghevli & M. S. Khan (1978) 5 See, for example, C. Bresciani-Turroni (1937, pp. 66-67), F. D. Graham (1930, pp. 37-45) and P. C. Witt (1983) for Germany; Z. Landau & J. Tomaszewski (1985) pp. 43-44 for Poland; L. L. Ecker-Rácz (1933) pp. 110 for Hungary and E. März (1948) pp. 501-503 and J. Van Sickle (1931) for Austria. revenues. Yet, if the Oliveira-Tanzi effect is present, a sudden stabilization should bring a very quick and possibly very strong recovery of tax revenues, which very clearly would have nothing to do with any kind of "reform". The relevance of alleged fiscal "reforms" for the end of the hyperinflations has to be established by distinguishing how much of the observed improvement in tax collection was due to "reforms" and how much was a consequence of price stability. The chapter is actually organized around this simple idea. The next three sections examine the fiscal measures undertaken during the stabilizations of Austria, Hungary, Poland and Germany. Section 7.5 brings an analytical interpretation of the role of fiscal policy in these episodes. The last section summarizes the main findings and comments briefly on the fiscal difficulties observed more generally during the early 1920s.

7.2) The League programs: Austria and Hungary

Although the evolution of in Austria and Hungary followed very specific paths, these countries share the origin of their problems - the sharp reductions in their territories and populations determined by the dismemberment of the Habsburg empire - and the fact they became basket cases of stabilization programs conceived and managed by the League of Nations, a more stringent and interventionist version of its outgrown, the IMF programs of our days. Indeed, the empire dismemberment has caused many problems, some of them of a fiscal nature. Tables 7-1 and 7-2, reporting annual fiscal accounts of the new republics, provide some indications in this direction. Table 7-1 Austria: closed accounts budgets, 1920-1924 (Millions of gold crowns) 1923 - 1st halfc 1923 -2nd halfd 1920ª 1921ª 1922b estimatef actual estimatef actual 1923e 1924e Revenues 211.7 281.4 215.1 158.4 210.5 188.7 272.8 483.3 623.4 Expenditures 567.5 673.8 672.5 299.5 296.5 269.4 296.7 593.2 632.4 Deficit 355.8 392.4 457.4 141.1 86.0 80.7 23.9 109.9 9.0% Rev./Exp. 37.3 41.8 32.0 52.9 71.0 70.0 91.9 81.5 98.6 SOURCES and OBSERVATIONS:(a )Fiscal years of 1919/1920 and 1920/1921, July to June, from J. V. Van Sickle (1931 pp. 66 and 72. (b) League of Nations estimate for October of 1922 annualized, from League of Nations (1926a) p. 33. (c) Ibid. p. 49. (d)Difference between values for 1923 full year and 1923 first half. (e) Full fiscal year, January-December, ibid. pp. 110-111. (f) Original estimates of League's program. All values converted into gold crowns with annual average exchange rates from J. van Walré de Bordes (1924) pp. 114-139.

It is important to note first that in both cases some nominal figures have been deflated with the help of annual averages of exchange rates which might have produced distortions, but in both cases the use of alternative methods of deflation - i. e. wholesale prices - does not alter the interesting result that the levels of expenditure before and after the stabilizations - which was achieved in the end of 1922 in Austria and in the beginning of 1924 in Hungary - were roughly similar. This is somewhat surprising given the unambiguously orthodox orientation of the programs implemented by the League in each country. The composition of expenditures, however, was markedly different in both cases reflecting important adjustments of these economies to their new economic realities. For the first budgets of the new Austrian Republic, food subsidies, the operational deficit of state undertakings, especially railways, and administrative expenses associated with the excessive number of government officials were the items weighting more heavily on expenditures. To a very significant extent these problems stemmed from dismemberment; the new Austria - a 6 million inhabitants country - inherited the administrative machinery of the Habsburg monarchy, which was considered overdimmensioned even for a 30 million inhabitants empire. Most agricultural land has been lost, and railways had to be reconstructed and routes redrawn in light of the new of the Danubean area. These structural problems would actually disturb the new republic for the whole decade6, and the important point to highlight is that the adjustment to the new realities did not necessarily require a reduction in . Two years after the League's intervention, during the fiscal year of 1924, for instance, the share of administrative expenses of total expenditure was reduced from 40.4% in 1922 to 29.6%, though dismissals, which up to December of 1924 reached 71,349 officials, implied an increase in the expenditures with pensions, which rose from 6.1% of total expenditures in 1922 to 13.5% in 1924. The railways' deficit was considerably reduced, reaching only 12.1% of total expenditure in 1924 (it was 21.8% in 1922); most importantly most of it (63.2%) corresponded to investment expenditure in

6Cf. E. Marz ( 1948) pp. 301, 630 passim and L. Pasvolski (1928) pp. 104-105. electrification programs7. In parallel there has been some significant increases in expenditure for social overhead, which actually made the levels of expenditure before and after the stabilization very similar. Table 7-2 Hungary: closed accounts budgets, 1920-1925 (Millions of gold crowns)

1924-25/1st halfb 1924-25c,b 1920-21a 1921-22a 1922-23b 1923-24a estimate actual estimate actual Expenditures 574.1 386.4 242.8 409.5 186.3 205.9 393.9 422.8 Revenues 192.4. 226.2 170.8 192.6 143.8 208.0 293.8 453.1

Deficit 387.5 160.2 72.0 216.9 42.5 -2.1 100.1 -30.3 % Rev./Exp. 33.5 58.5 70.4 47.0 77.2 101.0 74.6 107.2 SOURCES and OBSERVATIONS: (a)Fiscal years from July to June, nominal values from L. L. Ecker- Rácz (1933) p. 79) deflated with annual average exchange rates computed from price level indexes from ibid. pp. 61-62. (b)Estimates from League's program reproduced in L. Pasvolski(1928) p. 322.

A similar phenomenon is observed in Hungary, namely the League program marked significant shifts in the direction of expenditures with little, if at all, impact in the level of expenditures. The League's plan for Hungary prescribed budget cuts in several directions in addition to deep reforms in the administration, but from the very beginning the League officials made it very clear that a net increase in expenditure should be expected as the program was implemented. Like in Austria, the League insisted on dismissals - some 10,000 to 15,000 officials in this case - but at the same time the League understood that the salaries of the remaining public officials, which numbered some 160,000, "had so shrunk in value it appeared neither possible nor compatible with the interests of the State to refuse to take steps to increase them"8. Furthermore, public employees received special grants as compensation for the elimination of allocations in kind and of rent control. would be obtained with respect to state undertakings and , especially with respect to the operational deficit of the state railway system. But as observed in Austria, these savings would be mostly offset by increased expenses with pension payments and investment outlays9. For both countries, very significant increases in revenues explain the rapid

7 Cf. League of Nations (1926a) p. 33. 8 Cf. League of Nations (1926b) p. 98. 9 Ibid. pp. 99, 111. balancing the budget along with the stabilizations. In Austria state revenues more than doubled in real terms from 1922 to 1923 while the League's program contemplated an increase in revenues of only 33% for the fiscal year of 1923 coming mostly from "realistic" pricing policies for state undertakings and monopolies, and only to a lesser degree from new taxation. Very modest new taxes were introduced, notably one on railway traffic and a turnover tax, while rates of direct taxation, already considered very high by the 1921 report10, were actually reduced11. The actual performance of revenues in the first six months of the reconstruction period was totally unexpected not only for their value but also for their sources. The new tax on railway traffic was a failure and revenues from monopolies were far below target; on the other hand, the yield of direct taxation and of commodity taxes more than doubled the League's original estimates12. These taxes reacted very strongly to the stabilization of the currency which, at one stroke, eliminated problems of valuation, underindexation and losses caused by lags in collection, a common phenomenon in countries whose fiscal systems had evolved in an environment of stable prices13. Thanks to price stability, and despite the League's measures to reduce direct taxes, they contributed with roughly one fourth of all revenues. The League's plan had estimated their contribution to be 14% and the estimated pre-war value was 18.7%14. Table 7-3 shows that for the first six months of the League's intervention revenues were, on average, about 70% of expenditures and in the second semester this was raised to numbers between 82.5% and 98.0% of expenditures, which may be indicative of the size of the Austrian fiscal deficit correcting for the effect of inflation on tax yields, or if we control for the Oliveira-Tanzi effect.

10 League of Nations (1921) p. 36. 11 J. V. Van Sickle (1931) p. 195. 12 League of Nations (1926a) p. 50. 13 J. V. Van Sickle (1931) pp. 203-204. 14 Ibid. p. 202.

Table 7-3 Austria and Hungary: monthly budgets (for the first reconstruction period)

A u s t r i ab H u n g a r yc

montha expend. revenues deficit % expend. revenues deficit % 1 45.4 21.1 24.3 46.5 30.5 17.9 -12.6 58.7 2 52.0 21.7 30.3 41.7 33.8 29.5 -4.3 87.3 3 52.0 35.9 16.1 69.0 36.7 30.9 -5.8 84.2 4 51.1 50.1 1.0 98.0 33.7 35.6 1.9 105.6 5 49.2 40.6 8.6 82.5 34.0 49.2 15.2 144.7 6 46.8 38.6 8.2 82.5 37.2 44.9 7.7 120.7 d totals 296.5 d 208.0 88.5d 70.1d 205.9 208.0 2.1 101.0 SOURCES and OBSERVATIONS: (a) For Austria month 1 is January of 1923 and for Hungary is June of 1924. (b) Collected directly from the Monthly Reports of the Commissioner-General, deflated with monthly average exchange rates from J. van Walré de Bordes(1924) pp. 114-139. (c)In gold crowns from J. Parke Young (1925) vol. II, p. 326 and from the provisional budgets collected from the Monthly Reports of the Commissioner General. (d)The values differ slightly from those of Table 7-1 due to different methods for transforming paper crowns into gold crowns.

In the Hungarian plan the League's experts seemed more aware of the importance of the effects of inflation on the real yield of taxation. In their report of December of 1923 they referred to the "proved results of the Austrian experience" and argued that "a substantial part" of the required increase in revenues "may be expected from the automatically better returns (in terms of gold value) from existing taxes (as in the case of Austria) when the stabilization of the currency is effected"15. Yet, the League's experts could never expect a full repetition of the Austrian experience, and thus they devised some scope for fresh taxation. A new land tax was introduced, but its contribution to total revenues during the first reconstruction period was only 3.7%, gradually rising to around 10% in the subsequent periods16. Increased yields were also expected from the taxes on profits on house property, in view of the modifications in the rent control legislation, but these represented less than 1% of total revenues in the first six months of the program; only in later periods did they reach nearly a 10% share. All other taxes remained unchanged at least during the first six months of the program, after which the idea was to

15 League of Nations (1926b) pp. 64-66. 16 Ibid. p. 112. increase the share of direct taxation mostly at the expense of the turnover tax, whose rates were reduced in absolute terms. Indeed direct taxes represented 16.2% of revenues in 1924-25 and increased its share to 21.2% in the next fiscal year while the turnover tax had its contribution reduced from 27.5% to 18.5%. The expected net result of such tax alterations was a slow increase in overall revenues in order to reach the "taxable capacity" of the country, which the League estimated to be 400 million gold crowns, in the seventh semester of the reconstruction plan. Yet as in Austria, revenues were grossly underestimated, especially for the first six months of the program, so that even with the expenditure targets being exceeded by nearly 10%, the budget was balanced in September of 1924, the fourth month of the scheme, as seen in Table 7-3. Again the main contribution to this performance came from taxes that the program left untouched, or reduced, such as the turnover and commodity tax and customs duties17, and mostly as a result of the Oliveira-Tanzi effect. In sum, the stabilization programs determined important shifts in the direction of expenditure in both countries - as opposed to significant reductions - which actually represented a significant part of the adjustment of these economies to their new frontiers: the gradual resolution of issues like surplus officials and inefficient railways did not have a significant impact on the levels of expenditure, because dismissals were compensated by pension payments and by badly needed increases in real wages18, because of the new demands for social overhead and also because railways efficiency required economies but also extensive investment outlays. On the revenues side, a key role would be played by the Oliveira-Tanzi effect, which was recognized in the League's final reports on both programs. According to these reports, both authored by Arthur Salter, the diagnostics of the Brussels Conference of 1920 - the way to currency stabilization was budget balance - should not hold in either case where the currencies were "demoralized" and budgets "in chaos". In the midst of the hyperinflations, it was argued, "the budget deficit mainly as a consequence of the currency instability, incapable of calculation, no such order of events was possible". Furthermore, currency stabilization, i. e. pegging the exchange rate, was

17 Several imports prohibitions were substituted by tariffs during 1924, which, in addition to a moderate recovery of imports explains part of the recovery of customs revenues. 18 Even after substantial gains in 1923 middle grade government officials' wages stood at 56% and upper grade official earned no more than 49% of the 1914 values. Cf. International Labor Office (1925) p. 93. taken as an indispensable pre-requisite to orderly state finances and indeed the reports reached the important conclusion that "budget equilibrium followed, it did not precede"19.

7.3) Poland

Poland had lost its independence a century before in the Congress of Vienna, when she was portioned among the Russian, German and Habsburg empires. In 1919 Poland was reunified, but with frontiers very different from the ones of 1815; the new Poland was by all means an entirely new country. The comparison between the first budgets of the new republic and those following the stabilization, shown in Table 7-4, reveals a striking difference between the evolution of Polish and Austrian and Hungarian fiscal accounts: the Polish levels of expenditure nearly tripled in real terms between 1922 and 1925, passing from 647.4 million zloty in 1922 to 1821.4 million in 1925. This increase expressed the overall growth and development of the Polish public sector, which was being built out of the ruins of the bureaucracy left out by the three portioning empires. It also reflected the pressures generated by the needs of reconstruction: Poland suffered severe devastations in her territory from the war with Soviet Union, which lasted until 1920. Revenues could hardly accompany these tendencies at least until the stabilization in 192420 - when they jumped from a yearly level inferior to 400 million zloty to 1371.5 million, thus repeating the phenomenon observed for Austria and Hungary of a spectacular increase of public revenues immediately following the stabilization. The influence of inflation on state revenues was very clearly observed by contemporaries, most notably by the careful report of British financial expert E. Hilton Young and also by the summit of former ministers of finance, who gathered in mid 192321. The stabilization plan that started in December of 1923 explicitly recognized the Oliveira Tanzi effect, though given that the estimates of the level of revenues under

19 League of Nations (1926a) pp.75-76 and (1926b) p. 37. 20 Except for the first semester of 1922 when the budgetary situation was heavily influenced by the introduction of the extraordinary property tax as part of Michalski's attempt at stabilization lasting until June . 21 See E. Hilton Young (1924) pp. 23-24; E. Strasburger (1924) and F. Zweig (1944) p. 36. stable prices were somewhat dismal22, the plan anticipated the collection of the new capital levy introduced in June of 1923 that was scheduled to be collected during 1924- 1926. The latter represented an important contribution to state revenues especially during the first months of the program, as shown in Table 7-5, but yet again the recovery of the yields of existing taxes played the most important role to the observed budgetary improvement23. Little was accomplished in the expenditure side; general savings and expenditure cuts were proposed as part of the usual rhetoric of austerity and sacrifices, but the observed increase in public expenditure from 1923 to 1924 goes opposite to the discourse.

Table 7-4 Poland: closed accounts budgets , 1921-1924 (Millions of zloty) 1922 1923 1924 1925 I II I II I II I II Revenues 248 144 203 175 540 832 818 800 Expenditure 322 325 488 473 620 986 926 895 Deficit 85 181 285 298 80 155 108 95 % Rev./Exp. 74 44 58 37 87 84 88 89 Property taxb 75 10 - 2 93 97 35 24 Investimentc 59 71 130 184 44a 37a n.a. n.a. Coins/notesd - - - - 76 76 186 115 Debte 16 12 34 2 76 16 16 15 SOURCES and OBSERVATIONS: (a) From the preliminary accounts. (b)For 1922 consists of the Extraordinary Property Tax enacted by Michalski and for the later periods consists of Grabski's Capital Levy. (c) Refers mostly to state railways. (d)Includes small notes and subsidiary coins. (e)Includes internal and . From Republic of Poland (1926) pp.173-176 and (1931) p. 80-83.

The remarkable fact about the role of Polish finances in the process of stabilization is that despite the very significant improvement, the budget was not balanced as a consequence of the stabilization program. It is true that as part of the alleged "regime change" observed by Thomas Sargent the government was separated from the central bank, yet it is surprisingly neglected that the government retained

22 E. H. Young (1924) p. 30. 23 E. Rose (1924) p. 11. considerable powers to print money, though only small notes and coins24. The government effectively exercised these powers significantly in 1924 and 1925. During those years the total issuing of money by the Treasury reached approximately 450 million zloty, as shown in Table 7-4, which represented more than twice the existing money supply at the onset of the stabilization. Therefore, the fiscal "reforms" did not imply the establishment of a fiscal regime characterized by balanced budgets, but determined instead the start of an expansionary fiscal policy characterized by deficits ranging from 15% to 10% of expenditures financed mostly by money creation during 1924 and 1925, as shown in Table 7-4 .

Table 7-5 Poland: monthly budgets, December of 1923 to May 1924 (Millions of zloty)

Property All other Total Invest total %Exp/ tax revenues revenues expenditª expendit revs 1923- Decembera 1.6 30.5 32.1 42.1 96.0 33.4 1924- January 1.8 32.8 35.6 6.9 70.3 50.6 February 28.0 48.0 76.0 0.1 85.5 88.8 March 36.7 70.5 107.2 3.8 109.1 98.3 April 18.0 103.2 121.2 9.5 107.3 112.9 May 4.3 94.7 99.0 9.1 105.5 93.8 June 3.8 97.1 100.9 15.1 142.7 70.7 SOURCE and OBSERVATIONS (a) Preliminary figures from Republic of Poland (1926) pp.173-176. The totals reported for investment expenditure are not reported in the later closed accounts from which the totals for expenditure were taken. (b) Grabski's capital levy. From Republic of Poland (1931) pp. 80- 83.

It is interesting to observe that the increases in debt and in the issue of money by the Treasury during 1924 and 1925 entered the Polish budgetary accounts as "extraordinary revenues", an accounting trick which was noted by several historians of the episode25, but confused a number of other authors. John Parke Young, for example, in his account of the Polish stabilization, failed to note this detail and reckoned a budgetary

24 The Treasury was authorized to issue coins up to 150 million zloty for the fiscal year of 1924, representing nearly half of the existing money supply, and for 1925 this total was doubled, G. Zdziechowski (1925) pp. 45-46. 25 For example P. Robin (1932) p. 35. See also M. A. Heilperin (1931) pp. 135-136; F. Zweig (1944) p. 40 surplus for 1924 of 74 million zloty, merely reproducing the Polish preliminary accounts26. Ragnar Nurske, in his classic study of post-war inflations, also seems to assume budget balance in 192427, and more recently Thomas Sargent, drawing exactly on Parke Young and Nurske for his account of the Polish stabilization, also assumed that the government budget was balanced in 1924 as a consequence of the financial reforms28. The failure to take account of the true fiscal situation of Poland during 1924 and 1925 seriously undermines these authors' views on the Polish stabilization, especially Nurske's and Sargent's, who centered their explanations for the stabilization on the alleged move to a balanced budgeti. Thomas Sargent's idea that the newly established fiscal and monetary policies' strategies had provided backing for the currency in the form of the present value of the stream of government surpluses is contradicted by the presence of budget deficits in 1924 and 1925 largely financed by printed "unbacked" money, and no apparent intention to depart from such a "regime". In August of 1925, after a year and a half of stable prices, the zloty was allowed to float and was then stabilized again at a lower level. The London financial press attributed the devaluation to the "coin inflation"29, but in general it was widely accepted that the collapse was determined by a number of adverse circumstances including harvest failures, weak terms of trade, a tariff war with Germany, the dismal results of the Dillon & Reed loan and the deterioration in competitiveness determined by the wage inflation observed after the stabilization. Nurske himself denied the influence of fiscal policy on the episode: "yet, having regard to the fact that the principal cause of the disequilibrium - namely the harvest failure of 1924 - was a temporary one, it is plausible to argue ... that exchange stability could have been maintained if Poland had possessed a monetary reserve adequate to bridge a transitory gap of this sort"30. Sargent's explanation for the 1925 episode does not involve these issues: referring to the second part of the League of and Z. Landau & J. Tomaszewski (1984) pp. 278-279. 26 J. P. Young (1925) vol. II, pp. 182-184. The source of Young's figures was the Polish Statistical Annuary of 1923, published in 1924 , so that it could not bring but budget estimates . 27 League of Nations (1946) p. 26. 28 T. Sargent (1982) pp. 71-72 even reproduces a table with budgetary data from J. Parke Young (1925) vol. II, p. 65, though without mentioning that the figures for 1924 and 1925 correspond to the budget proposed by the government (not even the budget effectively passed in the case of 1925), thus very different from the closed accounts budgets shown in Table 7-4. 29 F. Mlynarski (1926) pp. 3-4. 30 League of Nations (1946) p. 26. Nations report on post-war inflations - the part not authored by Nurske - he argued that the collapse had been due to the "premature relaxation of exchange controls"31, though the existence of the latter is not mentioned anywhere in the literature32. In addition, Sargent mentioned "the tendency of the central bank to make private loans at insufficient interest rates"33, but in the League's report there is no mention of that. The report only argued that there had been no credit contraction corresponding to the reserves losses after April of 1925, as prescribed by the so called "rules of the game". It says nothing about credit at subsidized rates, and again no mention of that could be found elsewhere. In sum, Nurkse's and Sargent's explanations of the Polish stabilization are essentially at odds with the fact that Polish stabilization was achieved by a program whose fiscal policy was clearly "unsound".

7.4) Germany

The "emergency" fiscal decrees of October 11th and December 7th and 19th - which corresponded to the "reforms" to which the German stabilization has been usually attributed - were attempts to place the existing tax system "on a gold basis" and did not introduce any new taxes34. It turns out that these emergency decrees were implemented simultaneously with the stabilization, and quite obviously indexation provisions are immaterial under stable prices. Besides, tax indexation is technically difficult, therefore the effectiveness of attempts in this direction could certainly not be taken for granted ex- ante. In any event, the important point is that the astonishing growth in tax revenues after the stabilization observed in Table 7.6 was generated by the existing taxes35 or by the "indexation" of the existing tax system provided by price stability36. Table 7-6 shows figures for revenues and expenditures on a monthly and on a ten days basis deflated with

31 T. Sargent (1982) p. 73. 32 The League's report mentioning of "foreign trade controls" appear to relate to what in the modern jargon would be termed commercial policy, which is consistent with all accounts of the 1925 episode. Cf. League of Nations (1946) p. 108. 33 Ibid. p. 73. 34 Republic of Germany (1924) pp. 74-98; J. M. Robert(1926) pp. 137-144 and C. Bresciani-Turroni (1937) pp. 67-74). 35 C. Bresciani-Turroni (1937) p. 357. 36 Republic of Germany (1924) p. 32. exchange rates37. The recovery of tax revenues after the stabilization was absolutely extraordinary: from the beginning of November, when taxes financed less than 1% of expenditure, the budget was balanced in 40 days! It is even more remarkable when we remember that no new taxation was introduced in the process and that this was mostly the result of the influence of price stability on taxes. In the German case we observe quite the same picture of Austria and Hungary, namely the levels of expenditure before and after the stabilization were very similar, the improvement to the budgetary situation being almost entirely due to increased tax revenues. Thus the "reforms" observed in Germany had the same character of the ones that have been implemented by the League in Austria and Hungary, namely they were predominantly changes in the composition of government expenditure with little effect on the level of expenditures. In this respect it is remarkable that in 1922/1923, for example, payments on account of the Treaty of Versailles represented 38% of total expenditure while for 1924/25 only 13% of total spending was budgeted to this purpose, due to the revision of the London Schedule of reparations payments accomplished by the Dawes Plan38. The service (and also the real value of the stock) of the domestic public debt was another item that had its share over total expenditures significantly changed, especially during the two years preceding the period covered by Table 7-7. During 1919 and 1920, when prices grew by approximately 900%, the real value of the stock of the public debt fell from 58,515 million gold marks to 5,424 million: while the former figure represented more than seven times public expenditures in 1919-20, the latter was equivalent to no more than 80% of public expenditures for 1921-2239. For the fiscal year of 1921-22 the service of this debt was estimated at 9.8% of total expenditure, but the real value of the payments effectively made reached only 7%40. For 1923-24, these payments represented approximately 3% of total expenditures41.

37 Ibid. pp. 32, 77. 38 Ibid. pp. 29-32. 39 Ibid. p. 32 and Statistisches Reichsamt (1923) p. 42. 40 Republic of Germany (1924) p. 77.

Table 7-6 Germany: revenues and expenditures (May of 1923 to October of 1924 in millions of gold marks) Period Expenditures Revenues Rev.%/Exp. 1923- May 284.7 123.3 43.3 June 496.4 48.2 9.7 July 473.9 48.3 10.2 August 1--10 111.0 3.2 2.9 10--20 281.1 4.9 1.8 20--31 491.5 3.6 0.7 Total 883.6 11.7 1.3 September 1--10 67.1 2.6 3.8 10--20 168.7 2.6 1.5 20--30 453.4 9.2 0.2 Total 689.2 14.4 2.1 October 1--10 49.0 0.4 0.9 10--20 108.8 0.8 0.8 20--31 78.0 0.03 0.1 Total 235.8 1.23 0.5 November 1--10 134.2 0.1 0.1 10--20 28.5 0.4 1.5 20--30 258.7 10.6 4.1 Total 421.4 11.1 2.6 December 1--10 179.9 32.8 18.2 10--20 165.7 42.9 25.9 20--31 153.8 88.8 57.8 Total 499.4 164.5 32.9 1924- January 1--10 63.9 98.4 154.0 10--20 180.4 153.6 85.1 20--31 199.1 185.9 93.3 Total 443.4 437.9 99.0 February 478.6 339.8 71.0 March 485.6 526.8 108.4 April 472.1 396.4 83.9 May 511.0 449.5 88.0 June 440.9 382.3 86.7 July 452.0 494.8 109.7 August 489.4 482.7 98.7 September 495.7 522.3 105.4 October 620.0 613.7 99.0 SOURCES: Original paper mark figures on a 10 days basis from J. W. F. Thelwell (1924) p. 28 and 1925, p. 33, deflated with weekly exchange rates against sterling from The Economist, various issues(1923).

41 S. Andic & J. Veverka (1964) p. 237. Another important development was the increase in expenditure for broadly defined social purposes - a natural development within the framework of the Weimar state - that actually maintained a strong upward tendency throughout the 1920s42. It has often been observed that a decree of October 27th, 1923 established that approximately 25% of all public employees would be dismissed, 10% by January of 192443. But as in Austria and Hungary, it has been less often emphasized that the wages of the remaining officials were increased by 50% to 90% ni real terms after the stabilization, very much like what happened to the real wages of other categories of workers44, so that the net result of these measures on the public service's wage bill might not have been significant.

Table 7-7 Germany: revenues and expenditures, 1921-1925 (Millions of gold marks)

yeard 1921/22a 1922/23a 1923/24a,b 1924/25c expenditure 6651.3 3950.6 5768.0 6895.0 revenues 2927.4 1488.1 1802.5 7786.2 deficit 3723.9 2462.5 3965.5 -391.2 % rev./exp. 44.0 37.7 31.2 112.9 SOURCES and OBSERVATIONS: (a)The values for 1921/22, 1922/23 and for the period March-July of 1923 correspond to the figures reported in Republic of Germany (1924) p.32. (b)The figures for August-December of 1923 are from Table 6. For January-March of 1924 the figures are also from J. W. F. Thelwell (1924) p. 33 and (1925) p. 30. (d)For fiscal years starting in March.

In sum, it seems clear that the deficit was eliminated mostly by the effect of price stability on tax revenues; "drastic" fiscal reforms seemed to have played a minor role, if at all, in the episode. Whatever minimal overall fiscal restraint, real or rhetorical, would serve no purpose other than speeding the strict balancing of the budget, which might have been very useful for the negotiations towards foreign financial support by reassuring the government's adherence to orthodox finance. In light of this, the often celebrated episode

42 S. Andic & J. Veverka (1964) p.237 43 Republic of Germany (1924) p. 78. 44 In general the real wages of all categories recovered very quickly from the trough they reached at the end of the inflation regaining their pre-war levels late in 1924, G. Bry (1960, p. 62) and International Labor Office (1925) pp 16-17. As regards government officials specifically estimates for their levels of real wages, as a percentage of 1914, in October of 1923 are 44% (skilled) and 61% (unskilled). In June 1924 these levels would be 87% and 99% respectively. of the Rentenbank refusing to extend credit to the government beyond the pre-established limits loses much of its meaning, appearing as a hardly justifiable showing of inflexibility staged to impress foreign markets. It would be hard to conceive an inflow of capital such as what was triggered by the Dawes loan, without all the more decisive proclamations of support to the principles of "sound" finance.

7.5) The meaning of fiscal reforms

One important lesson of the experiences described in the previous sections is that the presence of large budget deficits in countries experiencing high inflations says little about the fundamental fiscal position of these countries, or about inflation-corrected deficits. This is easily seen in Graph 7-1 below showing the evolution of seigniorage, taxes, "total revenues" and alternative levels of expenditure for different levels of inflation:

G, R

G1 expenditure

G0 taxes

Ð

Graph 7-1: Budget deficits and inflation

The graph pictures taxes as monotonically decreasing with inflation, and total revenues as the sum of taxes and seigniorage. As observed in Chapter 4 the "total revenues" curve reaches a maximum at a level of inflation lower than the one that maximizes seigniorage45. The important point to observe is that independently of the value of the budget deficit at zero inflation, which should correspond to the "fundamental" fiscal position, for all three levels of expenditure one would observe very large fiscal deficits under high inflation; the mere observation of large budget deficits in these conditions does not provide in itself any indication on whether the economy is at "sound" positions like at A, or "unsound" ones like at E and I. Therefore, when taxes are adversely affected by inflation, the need for fiscal restraint or tax "reform" as part of a stabilization effort should be established by some measure of the zero-inflation-budget, or the "inflation-corrected" deficit. The previous sections have actually argued that the latter were very small, at least for Germany, Austria and Hungary; this is certainly not a general feature of all high inflation episodes, though the adverse influence of inflation over taxes is very commonly observed. Yet another method of checking the importance of the Oliveira-Tanzi effect is to estimate equations relating taxes and inflation. The available tax figures are subject to limitations, but the indications are indeed valuable. Table 7-8 shows regressions of taxes on inflation based on an exponential specification, i. e. T(P) = t0.exp(-t1 ):

Table 7-8 Regression of the Real Value of Tax Revenues on Inflation1 (t statistics in parentheses)

2 country log ô0 ô1 R DW 2 Germany 5.97 -1.08 0.69 1.40 (76.5) (-8.63) 3 Austria 1.33 -1.10 0.60 0.98 (34.6) (-2.01) SOURCES and OBSERVATIONS: (1) For sources of price data see Table 5-1. (2) Revenues in millions of gold marks from Republic of Germany (1924) p. 34. The period considered was January of 1921 to July 1923. (3) Revenues including only direct taxes, as estimated by J. V. Van Sickle (1931) p. 203. The period considered was January of 1921 to December of 1922.

The regressions reported in Table 7-8 show a significant negative association

45 considering the classic steady state result that ... between the real value of tax revenues and inflation for Germany and Austria. An interesting finding of Table 7-8 is that the values for †0 , which represent proxies for the zero-inflation level of tax revenues, seem to indicate that the predicted zero-inflation level of revenues are very close to the values actually observed immediately after the stabilizations. The predictions of Table 7-8 are of about 391 million gold marks for Germany and about US$ 600 thousand for Austria (for direct taxes only). The actual values for Germany were 314 million gold marks - average for the first three months of the stabilization (December, 1923 - February, 1924) and 389 million gold marks during the first two months of 1924. For Austria, the average monthly yield from direct taxes in 1923 was about US$ 860 thousand which is nearly 40% greater than the predicted value. This underprediction, for what it is worth, might be taken as indication of the existence of fiscal "reforms", but given the presence of serial correlation in the equation and the fact that, as reported in section 7.2, the rates for direct taxes were reduced, this underprediction should be seen with caution.

7.6) Summary and conclusions

The war and the economic, social and political events that followed determined a sizeable and permanent increase in government expenditures as a percentage of GNP in most European countries46, reflecting a trend towards an increased state participation in economic affairs, either in terms of direct spending, or an overall dirigisme, for military or for social motivations. The provision of "permanent" sources of revenues to accommodate this "structural change" certainly presented a major fiscal problem, but one that seemed to be solved at the end of the hyperinflations. The fiscal "reforms" introduced at this moment reflected an important change of priorities regarding public expenditures: the reforms comprised mostly shifts in the direction of expenditure with little impact, if at all, on the net budgetary result. The dismantling of the overstaffed bureaucracies of the former empires, the fact that domestic public debts were destroyed by inflation and the

46 In Germany it rose from 14.8% in 1913 to 25.0% in 1925 and in the UK from 12.8% in 1910 to 26.1% in 1920. Cf. C. Maier( 1984) p. 108. external debt - in the German case - was drastically reduced by the Dawes Plan, did not represent a meaningful reduction in public expenditure due to many new influences acting on the contrary direction. The marked increases in government expenditure for social purposes, and the recomposition of wages of public employees, more than made up for the savings often quoted as indications of strict austerity oriented fiscal policies. The recovery of the real yield of taxation after the stabilization through the Oliveira-Tanzi effect was the key to budget balance in all four cases examined. This means basically that budget deficits were to an overwhelming extent products of inflation, or that, to use today's terminology, "inflation corrected deficits" were balanced or at least manageable. "True" tax reforms had taken place at some point before the stabilizations, most likely during previous stabilization attempts such as Erzberger's in 1921 Germany, Hegedüs in 1921 Hungary and Michalski's in 1922 Poland. All these programs were specifically designed to address the fiscal issue, but the fact that they failed to arrest inflation does not imply that they failed in their purposes, it suggests instead that fiscal balance was not a sufficient condition for stabilization at a moment when other fundamental causes of inflation were still in full work. The essential point to retain is that the end of the hyperinflations involved many elements: the coordination device provided by dollarization, and the resolution of issues related to "fundamentals": a substantial improvement in the external position - which might be the revision of the reparations schedule, a territorial change (as the annexation of the coal exporting Upper Silesia region to Poland) or the reopening of international capital markets - and certainly budget balance. None of these was sufficient by itself; the stabilizations succeeded only when these pieces fit together.

Chapter 8

The stabilization in Austria and Hungary: the League schemes

8.1) Introduction

The end of the hyperinflations involved a number of factors and mechanisms that have been treated under different headings throughout this work. We provided an analytical discussion and the historical account of the dissemination of indexation and dollarization respectively in Chapters 2 and 7; we suggested that in a highly indexed/dollarized economy the coordination problems that we studied in Chapter 3 are mostly solved as the fluctuations of one single price, the exchange rate , become the determining factor for all nominal price and wage readjustments in the economy . It was suggested in Chapters 4 and 8 that inflationary finance was not an active determinant of inflation during these episodes and that the driving forces of the process should be found outside the monetary sphere. In Chapter 5 we argued that the determining factors of the hyperinflations could be associated with inconsistencies between real wage targets and external balance, so that the stabilization would depend basically on a major permanent improvement of these countries payments positions. Chapter 6 provided evidence on the magnitude of both the external imbalances and on the wage problem and suggested that the incompatibility was mostly "solved" or evaded by reopening international capital markets to these countries and the spurt of international lending of the second half of the 1920s. The role of this and the next two chapters is to assemble these several pieces and compose the individual pictures of the final act of the stabilization. The basic short term problem involved was one of fixing the exchange rates, but more fundamentally a more "permanent" solution for the external constraint, or for the wage problem, should be found. This chapter examines the solutions given to the Austrian and Hungarian problems; the distinctive feature of this solution was a large external loan under very strict conditionality and the enforcement of policies and procedures in close accordance with the resolutions of Brussels and Genoa. In both countries foreign financial help was seen by nationals from the very beginning as a sine qua non for the stabilization and a basic objective of nearly all finance ministers during the inflation period. The League loans and the capital inflows that followed would play the role of the "permanent" improvements in these countries payments positions, in the terminology of Chapter 5, necessary to reconcile external balance and wage demands. A high price would have to be paid for that, not only because the conditions to which the loans were made contingent were as nearly humiliating as a customs house occupation, but also because the League schemes failed to address the fundamental structural problems these countries faced. Non-adjustment under acceptable levels of wages and unemployment could only be sustained while borrowing abroad was available, and as observed in Chapter 2, whether these economies longer run problems would be addressed was a matter of the allocation of foreign funds to uses compatible with external balance on an intertemporal sense. By leaving the problem to be solved by "market forces", and by maintaining a strict compliance to "sound finance" there resulted that these loans were mostly put to "unproductive" uses. But in any event these problems laid beyond the policy horizon contemplated by the League. Their focus was strictly financial and a short run one; there was much to be done in this regard and this chapter is mostly devoted to see how it was done. This chapter is very simply organized, the next section examines the Austrian stabilization, section 8.3 treats the Hungarian case and the final section summarizes some of the main lessons of the two episodes.

8.2) The development of an international action: Austria

It is not easy to overstate the importance of foreign financial help for the Austrian stabilization; contemporary Austrian opinion seemed unanimous on its absolute necessity and the behavior of the economic authorities appeared to be governed by little else. No wholehearted stabilization effort was attempted before foreign credits were made available through the League, but it is also true that the domestic political stalemate posed on overwhelming obstacle to any stabilization initiative. It is interesting to examine the alternatives discussed domestically. On one side, the socialists and their unions sponsored a strong drive towards the pre-war levels of wages, and at the same time they were committed with the Anschluss idea or with the notion that the country was not "viable" with its new frontiers. Their anti-inflation program laid strong emphasis on budgetary reform and on a somewhat confiscatory capital levy, but also observed that an external loan was an indispensable part of the program1. More to the right of the spectrum the idea of the indispensability of an external loan was even stronger. Some business circles expected to connect the need of foreign currency for stabilization purposes to the country's need to undertake investment programs in areas such as energy, food and transport, which were identified as bottlenecks generated by dismemberment. This was, for instance, the position of the chairman of the Reparations Commission William Goode, and it is significant that these proposals were supported to a significant extent by the left2. Further to the right lay the conservative "sound money" proposals lined up with the Brussels Resolutions and the international financial establishment. The main item of this program was an independent central bank that would become the vehicle for foreign financial help through its subscription to be made especially abroad and through the continued support of the larger central banks3. The basic dilemma was therefore not around a large foreign loan and the inevitable loss of sovereignity it would entail; as put by an historian, "the disagreement between the opposition and the government, then, was not really one between self-help and foreign aid, between Austrian independence and dependence upon international capitalism, but between two kinds of dependence. Austria faced the choice between Anschluss with an old friend and ally with an insolvent economy - Germany - and dependence upon her former enemies - the Western Powers - whose economy could be very helpful "4. The ubiquitous emphasis on the foreign loan was an eloquent indication of the very precarious international position of Austria; this and the decisive pursuit of real wage levels of 1914 seem to conform very well with the picture presented in Chapter 5 of inflation as a product of the incompatibility between external balance and a "fair", at least as seen by workers, income distribution. Real wages could not really be detained from their drive towards 1914 levels, not only because the young Austrian democracy could not afford it, but also because wages have been dangerously close to what was seen as the

1 As demonstrated in Otto Bauer's financial plan of October 1921. Cf. E. Marz (1984) p. 417. 2 E. Marz (1948) pp. 553-554. 3 The main proponents were the foreign banks established in Vienna and their international sponsor was the influential president of the Dutch Central Bank Gehard Vissering. Cf. ibid. pp. 555-556. 4 K. von Klemperer (1972) pp. 183-184. subsistence levels. In these conditions the only possible solution for the Austria problem was, therefore, a complete redefinition of the country's international position so as to make compatible the wage demands and external balance under fixed exchange rates. An external loan was, in this sense, an essential first step not only to effect the stabilization but also to reopen international capital markets to Austria and to assure a steady flow of foreign capital into the country. More fundamental adjustments, however, would depend on the country being able to address its "structural" problems in the food, energy and transportation sectors and its capacity to direct international investment to these areas. The evolution of the Austrian inflation is by and large governed by the successive frustrations collected in the attempts to secure foreign financial help. The first important attempt in this direction was the request by the Austrian government and then the establishment in February 1920 of an Austrian section of the Reparations Commission. Since it was known that this new body "would be commissioned to elaborate a detailed scheme of reconstruction"5, the Reparations commissioner was received in Vienna with "hopeful curiosity instead of misgivings ... for it had become clear, in the meantime, that the reparation clauses of the Peace Treaty were unenforceable"6. Improved "expectations" on forthcoming aid and government intervention on the foreign exchange market not only halted currency depreciation but appreciated the crown from 280 crowns per dollar in February 1920 to 165 by the end of July. During this same period wage driven prices rose about 28% turning increasingly difficult for the government to sustain the peg. Since foreign financial help was not to be found Austrians faced the prospects of an "unaided" stabilization; the government coalition seemed unable to agree on a stabilization program and as the socialists left the cabinet the peg was suspended and the crown reached 660 to the dollar at the end of the year. Early in 1921 more concrete steps were taken towards foreign help; William Goode proposed the floatation of a loan as part of a stabilization program known as the "Goode Scheme". It prescribed a loan of 250 million dollars, which was about twice the real value of the money supply at this point, to be deployed in tiding the country over during fiscal reforms but especially in investment programs in areas such as water power

5 J. van Walré de Bordes(1924) p. 140 and also LN(1926a) p. 11. 6 E. Marz(1982) p. 425. and modernization of agriculture. An important indication of the position of creditors countries towards the Austrian problem is provided by the fact that the project was examined by the Supreme Allied Concil in January of 1921, and refused "in part because of the absence of positive garantees regarding the deployment of the proceeds of the loan...and in part because of the dimensions of the sum involved in a moment when the Allied Powers were themselves experiencing the world economic crisis [of 1920-21]"7. The "Goode scheme" appeared to be distant from the Brussels resolutions on which the Allies seemed to rely so much to orient their actions towards the international stabilization problem. Possibly in view of this the next Austrian move in March of 1921 was a formal inquiry into the possibility of using the Ter Meulen credits, proposed in the Brussells Conference, for longer term maturities so as to allow the floatation of a stabilization loan8. The proposal was well received and the Allied Powers declared they would renouce temporarily from their claims granted by the Peace Treaties provided that Austria complied with the terms established by the Provisional Economic and Financial Committee of the League of Nations, which by the time was trying to implement the Ter Meulen credits9. The League formed a mission of experts that devised a "comprehensive" plan based on whose adoption a large stabilization loan, as well as advances against Ter Meulen bonds, would be made contingent to. The plan followed very closely the Brussels resolutions in its emphasis on fiscal matters and its absolute disregard for the investment endevors proposed in the Goode Scheme. It was proposed that a new bank of issue entirely independent from the government would be formed and half of which would be

7 M. Pillet(1928) p.62. An alternative known as the "Loucheur Scheme" was also rejected with much less consideration L. Pasvolski(1928) pp.112-113 and J. Van Walré de Bordes (1924) pp. 140-14. 8 The Ter Meulen credits had been proposed and accepted in the Brussels Conference by the distinguished Amsterdam banker C. E. Ter Meulen. It envisaged mostly commercial credits (of maturities later determined to be no greater than five years) as Brussels concern was with "essential imports", and it should be incorporated into an International Credit Scheme to be managed by a special commission of the League. The scheme eventually approved by the League Concil in December of 1920 provided for the issue of bonds against some asset whose revenues would be administered by this League commission, which would later become the influential Financial Committee who sponsored all the League stabilization programs. See LN(1930a) annex and (1945) p.13 passim. 9 See LN(1945) pp.14-15. subscribed abroad10. Monetary expansion against government's paper would be immediately stopped while strict austerity measures would be imposed and a domestic forced loan would allow for financing the deficits to occur until the budget was balanced . In order to manage the foreign credits, the revenues allotted as garantees, and the execution of the program a Commission of Control would be formed and it would be composed of seven members, four of which chosen by the Financial Committee and the remaining three by the Austrian government. A clear emphasis was given to the fact that the plan was a product of the expert advice of an international organization and that the implied sacrifices would be inevitable or that the League was imposing measures that Austrians would have to take anyway. This was certainly a very significant improvement in the selling strategy of high conditionality loans on both ends of the bargain. All three Austrian parties reacted sympathetically to the plan, which allowed the government and the League to go ahead with the necessary preparations. On the other hand the "international" character given to the problem made possible to the League to attempt to raise the liens over Austrian property established by the Peace Treaties. This, however, resulted a long and painful process11 during which the Austrian economic situation suffered a continuous deterioration: prices rose 455% during the second semester of 1921 and at the end of the year the exchange rate was about to reach 10.000 crowns to the dollar. Riots and disorders seemed to signal that the collapse of the young republic could be very close; the Austrian problem acquired a truly international political dimension as it started to look like a legitimate threat to the stability of Central Europe. Ad-hoc credits were obtained from the Central banks of Czechoslovakia, Britain and France, to give Austria some breathing space until the Genoa conference; the credits were quickly dissipated, however, and the Conference produced no new development to the Austrian

10 The "Experts" Delegation further proposed the creation of a new gold currency, the Austrian Franc, which was not considered necessary by the Financial Committee which emphazised strongly that "prominence should ... be given to a statement that the Bank will make it its first duty to support, by all means in its power, the exchange value of the krone or of any new unit, and that it is intented at the earliest possible date to substitute the existing discredited notes for a completely new currency with a definite value". Cf. LN(1921) p. 8. 11 It involved no less than 18 countries, including those involved in the granting of relief credits. In many of these, as for example in the US, these matters had to become legislation. problem. A new conservative cabinet was appointed in the end of May and attempted unsuccessfully to implement the League's plan but based on a domestic subscription of a new bank of issue12. Chancellor Seipel then made a desperate appeal to the Allies from whom he heard that the matter should be resolved by the League, which should be able to propose "a program of reconstruction, containing definite garantees that further subscriptions would produce substancial improvement and not to be thrown away like those made in the past"13. The prospects of a significant loss of sovereignity implied in the adoption of the League plan induced the Austrian chancellor to flirt with other alternatives. Seipel embarked on a trip to Germany, Italy and Czechoslovakia and made no secret that "if need be we shall sacrifice our economic independence and even our sovereignity , by means of an economic or even a political merger with one of our neighbors, in fact with the highest bidder"14. Although Pan-German projects could hardly succeed at this point, a revival of the Anschluss issue could affect public opinion vary strongly15. Little could be expected from Prague which stood as one of the pillars of the European status-quo16, but in Italy Seipel proposed a customs union which though not regarded as an "ideal solution", according to an Austrian official, it "would have safeguarded our existence and forestalled foreign intervention"17. The very fundamental result of the trip, that was termed by an historian a "macheavellian gamble"18, was to force the Allies into the acceptance of the League's plan. Shortly after on September 6th Seipel went to Geneva to state officially before an enthusiastic League assembly that Austria accepted the League's intervention. The basic plan was the same offered by the experts in 1921 with some slight differences. The reconstruction loan would be expressly earmarked to cover the transitory budget deficits on which it would be helped by a domestic issue of indexed bonds and a

12 This failure has been attributed to the uncooperative standing of the foreign banks established in Vienna. Cf. E. Marz (1984) pp. 485. 13 LN(1926a) p.15. The last sentence obviously refers to the British credit given in the spring of 1922. 14 L. Aubert(1925) p. 41. 15 Edward Marz saw the German trip much as an act of "diplomatic cortesy". Cf. E. Marz (1948) pp. 587- 588. 16 Ibid p. 586. 17 Ibid p. 587ff. 18 E. Marz (1948) p. 588. short-term advance of £ 3.5 million. A Commissioner-General, instead of a Commission of Control, would be appointed to reside in Vienna to manage personally the proceeds of the loan, to accompany the fiscal measures previously agreed by the government, and to report on a monthly basis to a Committee of Control of the Garanteeing Governments. The Commissioner had powers to impose new measures and to halt any drawings from the loan proceeds if dissatisfied with the workings of the program. Nothing was established regarding foreign participation in the new bank of issue, though it was known to be very substantial: at least and an "advisor-director" would be appointed by the Commissioner-General to have veto powers over the board's decisions19. The main lines of the plan20 would be fit into three protocols which would be ceremoniously signed in Geneva and shortly after ratified by the Austrian Parliament.

Table 8-1 Austria: International reserves, real value of the money supply and cover ratio August 1922 to July 1923 (thousand dollars)

Date Money Supply1 Int'l Reserves2 Cover Ratio 1922- Aug.(1st) 29.877 6.637 22.2% Aug.(31st) 23.008 3.604 15.7% Sep.(30th) 31.887 5.179 16.2% Oct.(31st) 41.593 3.804 9.2% Nov.(18th) 44.721 3.517 7.8% Nov.(30th) 47.849 8.134 17.0% Dec.(31st) 57.122 18.986 33.2% 1923- Jan.(31st) 57.542 15.494 26.9% Feb.(28th) 58.912 15.568 26.4% Mar.(31st) 62.428 19.908 38.9% Apr.(30th) 64.083 21.183 33.0% May(31st) 67.719 24.570 36.3% Jun.(30th) 76.057 36.477 48.0% Jul.(31st) 79.578 42.280 53.1% SOURCES and OBSERVATIONS: (1) Computed by J. P. Young(1925) vol. II p. 296. (2) Computed from J. Van Walré de Bordes(1924) pp.206-207.

As it became known that negotiations had been concluded the recently recreated exchange controls institute, the Divisenzentrale, was able to stabilize the exchange rate in

19 And a mandate to last for three years after the termination of the Commissioner-General's functions. the end of August21. The floatation of the loans, however was still a long way ahead; a League official described this period as "a time of great anxiety", for although the depreciation was arrested "the scheme only existed on paper, and until these credits become available and the new bank of issue was founded, there was no real support to prevent a further decline; and the external loan was still a distant and doubtful prospect"22. The stock of international reserves held in the end of August could not afford much delays in the implementation of the League scheme as it can be seen in Table 8-1. The actual cover ratio was 16% in August/September but the average stock of reserves at this point barely reached 4% of the "normal" stable prices demand for money, as measured, for instance, by the average money supply in the first quarter of 192523. With the end of the hyperinflation the demand for money jumped to its "stable-prices" level in response to which the money supply grew approximately 247% from August to December. The cover ratio decreased from August until November when an increase in reserves was produced by the domestic floatation of an issue of indexed bonds amounting to approximately US$ 12.0 million subscribed in hard currency24. Exchange controls were exceptionally tight during this critical period and interest rates were very high at least until January 192225. But in January "public opinion in Vienna began to relapse into pessimism ... the floating of the first foreign loan - the short term loan - was delayed longer than had been expected ... [and] the public became seriously alarmed and began once more to question whether foreign aid would really be forthcoming"26. Finally in February the short term loan was floated which assured the continuation of the peg until

20 Including a joint declaration assuring the "political independence, territorial integrity and economic sovereignity of Austria". Cf. LN (1926a) p. 137. 21 According to a contemporary opinion "the tidings from Geneva brought the turn of the tide. Though it was uncertain what would emerge from the deliberations of the Concil of the League, everything seemed to show that this time the Austrian problem was receiving serious treatment. The foreign exchange speculators remained for a while 'in the fence' waiting to see what would be the outcome. In this circumstances the Divisenzentrale was at last able to stabilize the rates of exchange". Cf. J. Van Walré de Bordes(1924) p. 203. 22 LN (1926a) p. 30. 23 Approximately US$ 110 million. 24 Or 60 million gold crowns. Cf. E. Marz (1984) p. 504. Deducting this loan's contribution the cover ratio in December would be only 12%. 25 There are accounts of call money rates as high as 5% weekly in the end of 1922. Cf. ibid. p. 536 . With the opening of the new bank of issue in January a discount rate of 9% was implemented apparently without credit rationing. Cf. LN (1926a) pp. 95-96 passim and W. Layton & C. Rist (1925) pp. 122-124. the large loan was issued in June.

Table 8-2 Austria: real wages and real exchange rates (1913=100)

Date Real Wages1 Real Ex. Rates2 1922- June 73.1 81 July 77.0 93 August 80.9 102 September 84.8 118 October 89.3 118 November 93.8 112 December 98.3 113 1923- January 94.9 120 February 91.4 128 March 88.3 131 April 89.1 132 May 91.1 128 SOURCES: (1)Index of wages computed from ILO(1925) p. 85-86. (2)Real exchange rates are wholesale prices in terms of gold from LN(1926a) p. 88.

The net proceeds of the reconstruction loan reached 611 million gold marks or approximately 124 million dollars; deducting the amortization of past credits there remained a sum in the vicinity of 100 million dollars27. The real value of the money supply surpassed this value only in February of 1924 or nearly an year and a half after the stabilization; the loan was therefore nearly enough to convert the whole stable-prices- money-supply into gold. The loan was indeed a solution for the Austrian problem but not necessarily a long term solution. It certainly improved Austrian international position in many respects: Vienna regained her role as a financial and trading center, and the implied invisible incomes, several commercial treaties were obtained under the League's auspices and a steady inflow of foreign capital, though largely on short term account, was established. Yet, as observed in connection with the model of Chapter 5, the key to the stabilization was to maintain external balance but at the "target" or "fair" income distribution (or real wage). With the sudden end of inflation workers would be able to

26 J. van Walré de Bordes (1924) p. 206. 27 W. Layton & C. Rist (1925) p. 157. close the wage gap very quickly thus causing a deterioration in competitiveness.This is indeed observed in Table 8-2 which shows the behavior of an index of real wages and real exchange rates after the stabilization. With this deterioration in competitiveness little was accomplished in terms of balance of payments adjustment at least as seen in the trade balance which showed continued and strong deficits throughout the 1920s. As seen in Table 2-1 current account deficits as percentages of GDP averaged 8.4% in 1924-1926 and 6.1% in 1927-1928. Little was actually accomplished as far as the more structural adjustments that the new Austria should undertake; the League program did not really give any significant contribution in this respect, much on the contrary the League's obsessive emphasis on budget balance greatly reduced the government's initiatives as regards investment expenditure. The expected huge budget deficits failed to materialize, as observed in the last chapter in view of the extraordinary recovery of tax revenues after the stabilization. In these conditions, the proceeds of the reconstruction loan were put to uses like to form provisions and guarantee funds for its own repayment and to sustain "sound" cover ratios - one could hardly think of more "unproductive" uses. Besides, fiscal austerity and dear money maintained the economy on a chronically depressed state which was obviously not conductive to private investment activity. Such astonishing contrast with the reconstruction strategy implied by the Marshall Plan after World War II - that was noted in Chapter 2 - did not fail to be observed by Austrians28. In sum, bottlenecks in agriculture, energy, and transport sectors could be basically solved during the 1920s by a high level of imports made possible by borrowing abroad. Some state initiatives, made timid by the laissez-faire philosophy implanted by the League plan, and some direct foreign investment did address some of these issues but without any appreciable effect on the Austrian international accounts. This state of things could persist during the 1920s but not without its tensions; problems of high unemployment of scarcity of capital became nearly chronic complaints. As an exemplary product of the ideas of reconstruction spoused by the authorities of the 1920s, Austria became a debtor economy and thus like many others would pay a heavy price for that in the early 1930s.

28 E. Marz (1984) pp. 503-504 and G. Harberler (1982) pp. 66-67.

8.3) Following the precedent: Hungary

The notion that foreign financial help was essential for the Hungarian stabilization grew out of the successive failures collected in stabilization attempts before the League intervention. The first attempt was conducted immediately after the withdraw of the Romanian occupation army, completed only in April of 1920 and followed closely the plan put into effect successfully in Czechoslovakia the year before. The government undertook the stamping of the Austro-Hungarian banknotes in circulation within the new Hungary and used the occasion to attempt a deflationary policy through the retention of a portion of the notes. Prices remained fairly stable from May to October of 1920, but as the exchanges fell approximately 40% and prices rose 23% in the last two months of the year the government decided to launch a wholehearted stabilization experiment under Finance Minister Roland Hegedüs. The new Minister of Finance counted on the unqualified support of the business community; his nomination was received with "enthusiasm" and the announcement of his plans "produced a great impression" especially abroad29. Hegedüs program was the exemplary orthodox stabilization program centered on budget balance and the complete stoppage of money creation. It is significant, however, that Hegedüs had a very clear purpose the resort to an external loan at some point in the future; according to a historian, the plan "was to be carried out as a precondition to gain the confidence of the foreign money market which ... once convinced of an effective Hungarian financial policy and will in self-help would come in to help keep the stability of the currency"30.

29 E. Hantos(1927) p. 63. Hegedüs was professor of financial and fiscal science at the University of Budapest, for a while director of the Commercial Bank and president of the Association of Hungarian Banks and Savings Banks. Hegedüs "was a true representative of the alliance between the traditional Hungarian ruling class and the new business elite ... after the difficulties of revolution and counterrevolution whose economic policies ... were harmful to business interests , Hegedüs was regarded as the man who would carry out an economic policy promoting economic restauration and stabilization ". Cf. G. Ránki(1983) p. 525 and M. Mitzakis(1925) pp. 150-151. 30 Emphasis in the original. Cf. E. Boross(1985) p. 202. According to another historian, "one of the objects pursued by Dr. Hegedüs in undertaking drastic measures for the balancing of budgets, was to create a condition, in which Hungary might be able to raise foreign loans for the purpose of making up the deficit in her balance of payments". Cf. L. Pasvolski (1928) p. 307. Indeed, during the first semester of 1921 the money stock remained roughly constant while the exchanges appreciated approximately 55% and prices fell by 38%. As the exchanges started to show signs of weakness in June, Hegedüs insisted upon tightening the fiscal contraction but the Parliament, alarmed with the very high levels of unemployment, was reluctant and eventually refused to pass the proposed fiscal reform leading to his resignation. Many historians attribute Hegedüs failure to difficulties in implementing and maintaining budget balance31; yet the episode seemed to demonstrate that the Hungarian problem could not be solved by fiscal contraction or by unemployment. In this connection there seems to be a consensus among historians that the experiment "showed definitely that the financial rehabilitation of Hungary was impossible as long as the international position of the country remains what it was ... [therefore] the failure of Hegedüs' program of reforms clearly indicated the need for foreign financial intervention"32. But as in the other countries the problem was not merely that Hungary faced a nearly unmanageable payments position but this combined with the inevitable recovery of wages towards the pre-war levels; the incompatibility between the need for increased competitiveness and the desire for higher wages lay at the root of the Hungarian inflation. This is illustrated in Chart 8-1 by the behavior of the real exchange rate and by the somewhat scanty information available on real wages summarized in Table 8-3. It is interesting to observe in the chart that the real exchange rate shows an unambiguous tendency towards depreciation during the early half of the period, or up to the peak observed in November of 1921. This tendency was interrupted three times by aborted stabilization attempts that maintained exchange rates stable for some time (or produced appreciation) while workers attempted to obtain real wage gains. The first episode was the deflation simultaneous with the stamping of the old imperial notes, the second was the Hegedüs program and the third was an experiment with exchange controls that succeeded to hold exchanges stable early in 1922. In each of these episodes workers

31 L. L. Ecker-Rácz(1933a) p. 84, L. Pasvolski (1928) p. 307 and G. Ránki (1983) p. 526 and E. A. Boross(1985) p. 203. 32 L. Pasvolski(1928) p. 307. See also L. L. Ecker-Rácz(1933a) pp. 96,110 and 113 and (1933b) p. 471, LN (1926b) p.11, J. Guillemain (1925) p. 109 and J. P. Young(1925) vol. II p. 119. managed to regain some ground but at the cost of weakening competitiveness33.

Chart 8-1 Hungary: Indexes for real exchange rates, 1919-1924

3,5 Nov.1921

3,0

2,5

2,0

1,5

1,0 May.1921 Jun.1922 0,5 Jul.1920

0,0

jul/19 jul/20 jul/21 jul/22 jul/23 jul/24 jan/19mar/19 mai/19 set/19 nov/19 jan/20 mar/20 mai/20 set/20 nov/20 jan/21 mar/21 mai/21 set/21 nov/21 jan/22mar/22 mai/22 set/22 nov/22 jan/23 mar/23 mai/23 set/23 nov/23 jan/24mar/24 mai/24 set/24 nov/24 SOURCES and OBSERVATIONS: Value of the gold crown in terms of paper crowns divided by Pester Lloyd wholesale price index from L. L. Ecker-Rácz (1933a) pp. 61-62.

The information on real wages in Hungary is not very good and it is available only for a few points in time, being difficult to infer what happened in between. The behavior of real wages observed in Table 8-3 seem to contrast to what is observed elsewhere for there seems to be an upwards trend. After a slight fall from October of 1921 to September of 1922 real wages rose very significantly, between 40% and 50%, through September of 1923 and some additional 15% to 20% to September of 1924. This seems consistent with the continuous deterioration in competitiveness shown in Chart 8-1 from the Autumn of 1922 up to the end of 1924.

33 As regard the third episode, for instance, it was observed that "as the purshasing value of the monetary unit sank to its real exchange value the demand for higher wages become more insistent to meet living expenses , and because the export of industrial articles was only possible on account of cheap labour ... at the present time over 70.000 industrial workers are out of work or on strike". Cf. R. J. E. Humphreys (1923) p. 5.

Table 9-3 Hungary: Indexes for real wages 1921 - 1924 (1914=100)

categories Oct.1921 Sep.1922 Sep.1923 Sep.1924 Skilled Workers 46 43 65 73 Semi-Skilled 48 44 63 71 Unskilled 58 49 66 75 Females 44 40 64 70 Juveniles 59 46 62 79 SOURCE: ILO (1926) p. 92.

This apparently singular behavior of real wages can be explained by the actions of the authoritarian government. It is important to observe that the levels of real wages in Hungary are much lower than what is observed elsewhere, even after the stabilization. In the other three countries real wages were pushed up until recovering pre-war levels before the start of the hyperinflation; at this point Hungarian wages barely reached 50% of pre-war levels. During the last months of the inflation real wages in Hungary were not significantly greater than we observe elsewhere; the singularity of the Hungarian experience seems to be the fact that there was not a peak in real wages before the hyperinflation, or that there was no (temporarily) successful wage-push as observed in the other countries. This is not at all incompatible with the existence of an incompatibility between desired wages and external balances to be "solved" by inflation; increases in real wages are obtained in the model of Chapter 5 for increases in unemployment and/or downwards "revisions" in wage demands by negotiation or by force. The authoritarian regime's policies towards unions did manage to impose the burden of adjustment on the working classes: pre-war wages would not be reached even by the early thirties and unemployment averaged 15.4% for 1924-1926, a marked contrast to what is observed in the other cases. As far as medium term adjustment problems were concerned the reopening of international capital markets to Hungary would play a very important role in removing the external constraint or at least in permiting some recovery of real wages and reductions in unemployment. The short term stabilization problem depended on a loan, and Hungary faced some very serious difficulties in this respect. After the Hegedüs failure the repeated initiatives of the Hungarian authorities towards obtaining foreign credits34 met two main obstacles: one was Hungary's reparations obligation which was far from being handle by the Allies with the same benevolence they had with Austria35; and the other was the especially tense relations between Hungary and her neighbors36. The implementation of the League scheme in Austria, and its apparent success early in 1923, left Hungary no alternative to obtain foreign credits other than to adopt a similar program. Despite its obvious costs, the League scheme offered Hungarians an unique opportunity to obtain a favorable settlement of the reparations bill37; it also opened new perspectives as regards the relations between Hungary and the other Successor States not only as regards the political and territorial disputes that could be arbitrated by the League but also with respect to commercial treaties that could reactivate, at least to some extent, Hungarian exports to the Danubean area38. The Austrian precedent was very important to circumvent the diplomatic intricacies involving Hungary, the Reparations Commission, the creditors of relief credits and the other Successor States. In the late fall of 1923 when it became clear that the Reparations Commission would invite the League to draw a stabilization program, as it effectively did in October 17th, the exchange rates were stabilized. The government, however, did not have the means to sustain the stabilization for very long; international reserves at this point were reportedly insignificant and the floatation of the stabilization loan lay ten months ahead. This would be dramatically confirmed at the end of the year when the financial crisis originated by the stock exchange crash in Vienna was communicated to Budapest resulting in a run on the crown39; though that was also partly generated by "some difficulties in the loan negotiations [that] had aroused fears that they would not succeed"40. The crown fell 13% in December, nearly 60% in January and further 5% in

34 M. Myers (1945) p. 506, M. Mitzakis (1925) p.169, LN (1926b) p.11 and H. Clay (1957) p. 190. 35 H. G. Moulton & L. Pasvolski (1932) pp. 234-236 and I. Berend & G. Ránki (1974a) pp. 184-185. 36 L. Pasvolski (1928) p. 308. 37 G. Ránki (1983) p. 528. 38 L. L. Ecker-Rácz (1933a) pp. 114-115. 39 M. Mitzakis (1925) p. 160 and LN (1926b) p. 28. 40 LN (1926b) p. 28.

February without any attempt to arrest that movement. In March, with a League delegation already installed in Budapest and the solemn signature of Protocols similar to the Austrian ones in Geneva, the depreciation was halted; yet the government still lacked reserves to sustain the peg. A domestic "forced" indexed loan41 was floated between March and June yielding approximately 6 millions dollars; an advance of 3.4 millions dollars was obtained from Budapest banks on security of grain stocks in April, and the remains of the proceeds of the liquidation of the Austro-Hungarian bank, approximately US$ 2 million, were all used to prevent further depreciation. The gold value of the money supply was US$ 42.2 million in February and US$ 24.1 million in March so that these contributions, though significant, were far from being decisive. In April it was known that New York bankers refused to place the US tranche of the reconstruction loan; the Bank of England then advanced £ 4.0 million, or approximately US$ 18 million, but contingent on the stabilization being made with respect to the pound sterling, which was promptly effected42. The subscription of the new bank of issue was closed in May and 50% of the capital, the equivalent of US$ 3.1 million was paid up in gold. When the new bank opened for operations in June its reserves totaled only US$ 9.7 million covering only 30% of the money supply as shown in Table 8-4 .

Table 8-4 Hungary: international reserves, dollar value of the money supply and cover ratio, 1924 (millions of dollars)

Month Money Supply Int'l Reserves Cover Ratio June 31.8 9.7 30.5% July 39.4 17.2 43.6% August 47.6 20.3 42.6% September 53.5 21.3 39.8% October 52.3 23.9 45.7% November 57.8 25.7 44.5% December 58.7 27.3 46.5% SOURCE: J. P. Young(1925) vol. II p. 32.

The reconstruction loan would be floated in July and August providing a net yield

41 Composed of bonds indexed to the sparkrone price. 42 F. de Fellner (1925) p. 282, M. Mitzakis (1925) p. 283 and L. Pasvolski (1928) pp. 314-315. of approximately US$ 51 million. The loan was thus much smaller than the Austrian one; this was due to the fact Hungary had a lower stable-prices money supply, around US$ 80 million as compared to Austria's US$ 110 million. Hungary was also a much more closed economy commercially (exports represented about 24% of GNP for Austria and 18% for Hungary) and financially. Besides it seemed obvious that the Austrian loan had been too big. The Hungarian plan had only slight differences with respect to the Austrian one. The reconstruction loan would enjoy no garantee from the Allies, being secured instead by certain government revenues, the customs duties, the sugar tax and the tabacco and salt monopolies proceeds, to be held in blocked accounts under the control of the Commissioner-General. A significant contrast with the Austrian scheme was that an effective schedule of reparations payments was established by which Hungary should pay an yearly average of 10 million gold crowns, which was equivalent to around 1% of 1926 exports, during twenty years to start after the reconstruction period43. The system was innovative in that the reparation payments were made in paper crowns to the Commissioner-General who could decide on the suspension of payments if he considered budget equilibrium to be endangered, and also should manage to effect the transfer of such payments, or to postpone it, as not to pressure the exchange rate. This was the origin of similar arrangements implemented by the Dawes Plan in Germany44. Financial policies were not as contractionary as in Austria, though still very much so, as there seemed to be a feeling that fiscal and monetary restraint had been excessive in Austria. The new bank of issue applied the same discount rate inherited from the old, namely 10% for credits in sparkrone, and the Commissioner consented in utilize the proceeds of the loan for investment projects much earlier than in Austria. Unemployment was high, averaging over 15% of unionized workers in the second semester of 1924, yet, as in Austria, a large external loan under strict conditionality was the fundamental element for the success of the stabilization for it redefined entirely the Hungarian payments position. Following the loan a steady inflow of foreign capital into Hungary was established, as observed in Chapter 2, which accommodated the chronic trade deficit

43 The reconstruction period was considered to be the period within which the Commissioner-General would be in residence, which was initially estimated to last two years. that Hungary presented throughout the 1920s. No doubt these trade deficits can be traced, to some extent, to the deteriorating competitiveness produced by the workers' pursuit of pre-war real wages. It is also true, however, that in contrast with the other countries real wages in Hungary stabilized at levels no greater than 80% of pre-war levels so that works did accept a reduction in the standard of living. On the other hand the League did not exercise a healthy influence on the country's willingness to undertake industrialization. On the contrary the League fostered laissez-faire notions and emphasized the country's agricultural comparative advantage wiping under the rug all the necessary structural adjustments to the new frontiers as all as the tensions between the backwards agricultural sector and the emerging industrialists. No doubt the Hungarian payments disequilibria that persisted unnoticed during the 1920s, thanks to capital inflows and "sound finance", resulted from this lack of adjustment. Like the others, Hungary would pay a very high price for that during the early 1930s when foreign capital ceased to be available.

8.4) Summary and Conclusions

The mechanism of stabilization in Austria and Hungary was very simple, a large loan could convert the money supply almost entirely on gold; this meant to shrink inflation to the levels observed in the gold standard countries. Then a continuous inflow of foreign exchange was established that assured a medium run compatibility between external balance and target real wages. Adjustments in the margin were provided by contractionary policies that basically adequated the current account to the availability of foreign capital such as to maintain a very high gold cover for the currency. In Hungary specifically a significant part of the burden of adjustment feel on workers - who had to withstand a significant reduction in their standards of living - which was basically attributed to the authoritarian government that ruled throughout the 1920s. The experience of Austria and Hungary provides a typical picture of a well behaved adhesion, even though forced, to the gold standard and perhaps the best possible demonstration of the principles of Brussels and Genoa. Yet it was an essentially financial solution for a problem that was only partly, if at all, a financial problem. The inaction of

44 LN(1926b) pp. 22-23. the League and of its local followers towards the more structural necessities of these economies would result that these economies structural problems would not be addressed. This non-adjustment could only be sustained thanks to the relative abundance of foreign capital in the 1920s; by the early 1930s when this ceased to be the case these economies would be again confronted with the same basic imbalances. In sum, these programs succeeded to arrest inflation, which, however, was not such an achievement in view of the amount of resources made available by the League loans; the real challenge for these programs was the medium and long run balance of payments adjustments. In this sense these programs failed and fortunately the lesson was learned, or at least it was remembered after the next war when the Marshall Plan offered a very significant example of an alternative strategy, as discussed at some length in Chapter 2.

Chapter 9

The stabilization in Poland: the battle of zloty

9.1) Introduction

This chapter concerns the final episode of the Polish stabilization or the process by which the exchange rate was maintained fixed. We discussed somewhat extensively in Chapter 7 the dissemination of indexation in Poland, so that we know that by fixing of the exchange rate the hyperinflation is stopped almost simultaneously by the indexation/dollarization mechanism. We know from Chapter 8 that the stabilization in itself solved most of the fiscal problems observed during the hyperinflation and that it reduced the fiscal deficits to quite manageable levels. For the Polish case in particular, it was shown in Chapter 8 that an expansionary fiscal policy was actually implemented. We suggested in Chapter 6 that the basic incompatibility between external balance and the desired level of wages would seem to be solved by "improvements" in Poland's international position accomplished during the inflation period and by borrowing abroad. This chapter is mostly addressed to examine the effort of fixing and sustaining the exchange rates, which was what actually stopped the hyperinflation; but we also discuss briefly the nature of the latter improvements and especially the part they played in the stabilization effort . Polish historians often emphasize the fact that the stabilization was accomplished by "the country's own efforts"1 meaning that it did not involve foreign financial help. Though not entirely true the contrast between Poland's access to foreign finance and Austria and Hungary is very significant. The Poles had been very reluctant to adopt the Brussels recipes and had been decisively determined to avoid a League Scheme. That was in part a very characteristically Polish manifestation of national pride that was quite understandable at the circumstances surrounding the Polish independence. But more importantly it reflected the priority assigned by the Poles to their structural adjustment needs and its implied investment expenditure. This represented clear contrast with Austria and Hungary, but policy endeavors as such mean nothing if the objective conditions allowing such choices are not present. In this connection, the decisive factor in creating an alternative course of action was the annexation, or the reintegration, of Upper

1 Z. Landau & J. Tomaszewski(1984) p. 272.

Silesia in 1922; this represented a significant and "permanent" improvement in the country's international position. Upper Silesia improved considerably the perspectives for a stabilization effort, but the annexation took place almost simultaneously with the collapse of an orthodox stabilization attempt so that the timing favored the use of the newly gained capacity to import for investment purposes. The Polish stabilization of January 1924 differed in many respects from the Austrian and Hungarian. One significant difference was the choice of parity rate, for by choosing the market rate or above, less reserves would be required at first, according to what was argued in Chapter 5. Another difference was the character of financial policies, that we saw in Chapter 8 to have been expansionary, and yet another was the resort to foreign financial help in a smaller scale and from "peripheral" financial centers. A very significant contrast was the fact that Poland started the program on top of significant trade surpluses, so that even by establishing a parity rate that would create wage pressures and a deterioration of competitiveness, the Poles could hold the line for a significantly long period of time. In fact the latter threats did materialize and it is significant that even with bad crops, very liberal commercial policies and, more significantly, with a set-back in their attempts to reenter international capital markets, the Poles managed to resist for well over an year. The specter of the hyperinflation was no longer there when the zloty was allowed to float in 1925, but this time a recession and restrictive commercial policies had to be implemented at least until Poland could finally regain access to international credits by contracting a large "reconstruction" loan in 1927. This chapter is organized as follows: the next section examines the contrasts in attitude and policy alternatives between Poland and Austria and Hungary , and it also discusses briefly Michalski's stabilization attempt. Section 9.3 discusses Grabski's plan and the factors and circumstances responsible for its success and the "second round" of the stabilization, or the wage determined deterioration in competitiveness and its consequences are examined in section 9.4. The last section draws conclusions.

9.2) Stabilization, investment and the loan issue

Foreign financial help was a recurrent preoccupation of the Polish authorities throughout the 1920s. The first finance ministers of the new Poland strongly emphasized the necessity of foreign capital to help establishing the new state, but little could be done on this account this early. With the start of the war against the Soviet Union, the Polish government managed to receive financial aid from the Allies in substantial amounts, though mostly on the form of commodity credits. The amount of aid totaled the amount of 272 million dollars during the 1918-202, an amount of the same order of magnitude of the total value of Polish exports during this period. After the war the Poles renewed efforts to procure foreign loans, but at this time for reconstruction, investment and stabilization purposes, in this order of importance. No more than US$ 15 million could be obtained abroad in the next three years; an eloquent indication that these Polish priorities did not seem to match those established at Brussels. In any event, after demobilization, Poland seemed ready for the first serious stabilization attempt. In the end of 1921 a cabinet of experts with professor Michalski as Finance Minister, was commissioned to undertake the stabilization of the currency. Michalski's episode seemed a mirror reflection of the Hegedüs experience in Hungary. The budget was balanced with the help of a capital levy, the Treasury's indebtedness with the Central bank was maintained constant from November of 1921 to June of 1922 and the exchanges were roughly stabilized3. Inflation was not stopped, however, prices increased by 2.5% in December and in the next three months rose 3.8%, 7.1% and 15.8%. As in the Hegedüs episode the wage pressure was the origin of these price increases, as seen in Table 9-1. Despite the sharp increase in unemployment4 simultaneous with the plan's implementation workers made significant gains especially during the first months of Michalski's plan when inflation was under control. The resulting deterioration in competitiveness, on top of an already delicate payments position, and absence of any help from abroad eventually produced the collapse of the plan and Michalski's resignation in June.

2 Z. Landau (1974) p. 287. 3 G. Zdzichowski (1925) pp. 6-7. 4 Z. Landau (1967) pp.192-198, ILO (1925) pp. 115-116,175 and J. Szturm de Sztrem (1924) p. 396.

Table 9-1 Poland: Real Wages and Real Exchange Rates during Michalski's Tenure (January 1914 = 100)

Date Real Wages1 Real Exchange Rates2 1921- Setember 88.9 - 65 October 91.6 - 58 November 99.1 - 71 December 100.3 - 75 1922- January 101.1 81.5 81 February 98.5 76.9 76 March 100.9 86.7 73 April 93.5 93.7 83 May 96.9 95.8 82 June 93.7 95.5 87 SOURCES and OBSERVATIONS: (1) Weighted average of 7 categories reported in J. Szturm de Sztrem (1924) p. 396. (2) Wholesale prices in terms of gold. The first series correspond to official figures for January 1914=100, from Republic of Poland (1927) p. 21. The second series uses a different wholesale price index for deflating exchange rates; from J. P. Young(1925) vol. II p. 349 .

Like in Austria and Hungary the incompatibility between desired real wages and external balance, at least with international capital markets closed, appeared very clear. Foreign credits seemed the natural solution and the Polish authorities repeatedly approached international capital markets for help. But the Polish attitudes in this regard, and also as regards the country's adjustments to the new frontiers, stood in sharp contrast with those of Austria and Hungary. It is significant that the failure of the "sound finance" experiment under Michalski did not lead the government to the immobility of the hopelessness one observes in Austria and Hungary after the resignation of Hegedüs. The Polish government had very clear that deep structural adjustments had to be carried out in order to adequate the new Poland to its new frontiers. This implied the realization of a number of investment projects to which the government also assigned strategic importance; the outstanding examples are the redesigning and unification of Polish railways and the construction of a port alternative to Dantzig (Gdansk)5.

5 Dantzig was given by the Peace Treaties the status of a "free-city", though it was established that Dantzig would remain on a customs union with Poland for some undeterminate time. This, in principle, would assure the Poles access to the port , but in practice there were difficulties that led eventually to the construction of a new port in Gdynia just a few miles from Gdansk inside Polish territory.

Indeed, after Michalski's resignation the government sidelined its commitments to austerity and plunged into heavy investment spending notably on the state railways: in 1922 government investment expenditure totaled US$ 25 million representing approximately 20% of total government expenditure; in 1923 this total was raised to US$ 61 million accounting for nearly 33% of government expenditure6. From the end of 1921 to the end of 1923 the length of Polish railway network was increased by approximately 8.5% and the number of locomotives in operation rose by nearly 35%7. The Poles did not have much alternative as regards the financing of these projects; it is interesting that they went to foreign money markets but to see whether they could interest foreign investors on these projects and not like Austria and Hungary to procure a large stabilization loan8. But the contrast with Austria and Hungary was not merely a question of attitude; the investment projects carried out by the Polish government, and also the ones that Austria and Hungary necessitated, had a high import content, so that the binding constraint was not domestic financing - which could always be solved be money creation - but capacity to import. The Austrian and Hungarian positions in this regard were pitiful, and so was Poland's before the annexation of the coal producing and industrial district of Upper Silesia in the middle of 1922. The reintegration of Upper Silesia represented an extraordinary improvement to the Polish international accounts. Monthly exports averaged only US$ 5.1 million in the first semester of 1922, which represented approximately 45% of imports in this period; in the third quarter exports jumped to an average of US$ 12.3 million, which meant 112% of imports and in the fourth quarter it reached US$ 16.5 million or 97.5% of imports9. These trade results are even more significant if we consider the fact that with Michalski's resignation and the end of austerity the activity level was greatly increased in the second semester of 1922: the average level of unemployed workers in the first semester was 135 thousand and in the second semester it was reduced to 70 thousand10. Poland had been a net importer of coal before Upper Silesia; the levels of

6 Republic of Poland (1926b) p. 173. 7 Ibid p. 55. 8 Z. Landau(1974) pp. 286-287. 9 J. P. Young (1925) vol II p. 354, E. H. Young(1924) p. 53. 10 E. Wicker(1984) p. 5. domestic consumption were of around 18.6 million tons yearly and in and in 1921 domestic production had reached only 7.6 million tons. Upper Silesia added 30 .0 million tons of annual production, turning Poland into a net exporter of coal11. As regards industrial production Upper Silesia alone could produce nearly three times as much coal and steel, five times as much pig iron, more than four times as much rolled goods, and eight tomes more zinc ore than the rest of Poland12. Thanks to this circumstance Poland could maintain a consistently large level of imports13 which was very helpful for the reconstruction programs being undertaken. It is very significant that the Poles preferred to increase imports than the more "unproductive" piling up of reserves necessary to effect the stabilization. Polish attitudes towards foreign credits were distinctively different from Austrian and Hungarian ones not only as regard reconstruction and adjustment but especially as far as conditionality was concerned. The experience of 124 years of often repressive foreign domination and the traumas of the war of liberation led to a feeling highly contrary to anything that could loosely resemble foreign interference in domestic affairs. The perspective of seing in Poland something like what was happening in Austria and Hungary seemed, on one hand, to terrorize Polish authorities, though the obvious convenience of foreign credits produced a somewhat more ambivalent attitude. The issue was very much debated within Poland14, but this did not reflect on Polish diplomacy towards foreign money markets. In a careful account of the Polish efforts to obtain foreign credits a historian observed that "the real interest of the Poles was the gaining of access to foreign financial markets with a minimum blow to their national pride and with the need to take unpopular internal measures reduced to an absolute minimum required to open those foreign markets"15. Though little concrete action was taken, the discussion of stabilization was very active during 1923. After the assassination of the first elected president of the Polish republic in December of 1922, a coalition cabinet of pacification was formed and behind

11 A. B. Barber(1923) p. 63. 12 Z. Landau & J. Tomaszeweski(1985) p. 36. 13 It is simptomatic that the Polish preferred to increse imports than to pile up reserves in order to prepare for stabilization, certainly a more "productive" investment. 14 F. Zweig(1944) p. 39. 15 R. H. Meyer(1970) p.71. its authority summoned a meeting of all former ministers of finance to discuss the issue. The summit strongly supported the attempt to obtain foreign credits but acknowledged the difficulties in obtaining these credits in favorable conditions before a thorough stabilization attempt had started16. While negotiations were taking place in London17, the Poles, playing by the rituals of international money markets, invited British financial expert Edward Hilton Young, former Under-Secretary of the Treasury in Britain, to report on the Polish financial conditions. But the initiative had little effect on the British which seemed rather considering, as later would become clear, a plan through the League of Nations like the ones for Hungary and Austria18. But not only the Poles felt uncomfortable, to say the least, about the conditionality involved in the League scheme but it also feared that the blossoming cooperation between the British and the Germans would result in the British support to Germany regaining its leverage in Central Europe and in particular to German territorial claims over Poland19. In sum, the somewhat unorthodox attitudes of the Polish authorities towards reconstruction and the conditionality issue precluded the country's access to international credits. The annexation of Upper Silesia represented a very significant improvement on the country's international position yet it took place immediately after Michalski's failure, or in a moment at which the sentiment was not favorable to the sacrifices involved in another orthodox plan. But as inflation climbed to hyperinflation proportions during 1923, the government had to reconsider the stabilization problem.

9.3) Grabski's Stabilization Plan

In the end of 1923 an extra-parliamentary cabinet headed by Wladislaw Grabski was empowered and in January 11th 1924, it was granted plein pouvoirs to conduct a stabilization plan. The failure of the loan negotiations in London led Grabski to "get rid

16 M. A. Heiperin(1931) p.105, L. Czarnozyl(1930) pp. 63-68 and E. Strasburger (1924). 17 T. Mincer(1927) p.19. 18 H. Clay(1957) p.258 passim and L. Chandler(1958) p.392 passim . 19 Z. Landau & J. Tomaszewski(1984) p. 272 and Z. Landau(1974) p.285 passim. of the Young mission in a diplomatic manner"20 and to turn his attention to the American capital market; a loan was proposed to J. P. Morgan, but refused in view of of "budget instability"21. Grabski went ahead with his plan anyhow, challenging conservative opinion that at this moment was "somewhat aghast" on the issue; The Economist referred to the Polish plan as "a break with consels of caution in financial and monetary policy, and shows us a picture of a young and inexperienced state , without even a tradition of settled monetary conditions and without external help, attempting the difficult problems of financial reconstruction and currency reform concurrently"22.

Table 9-2 Poland: international reserves, real value of the money supply and cover ratio (millions of dollars, December 1923 to June 1924)

Date Money Supply1 Int'l Reserves2 Cover Ratio 1923- December 29.3 9.0 30.7% 1924- January 36.4 9.8 26.9% February 57.7 18.6 32.2% March 67.4 23.7 35.2% April 65.1 29.8 45.8% May 79.3 43.4 54.7% June 79.9 65.6 82.3%

SOURCE: J. P. Young(1925) vol. II pp. 348-353.

The government's position in January was not very comfortable, as seen in Table 9- 2. In fact it was worse than that; the net reserve was of only US$ 2.5 million. In addition to that, an amount of US$ 4.0 million in hard currency had been deposited with the Treasury as a result of an agreement between the government and industrialists as regards the first installment of the capital levy passed in August of 192323. With these corrections the cover ratio in January would be reduced to approximately 18% which correspond to approximately 6% of the stable-prices money supply24. The margin of success was indeed

20 Z. Landau & J. Tomaszewski(1984) p. 272. 21 P. Robin(1927) p.19. 22 Apud L. Smith(1936) p.150. 23 G. Zdziechowski(1925) p. 15. 24 As measured by the real value of the money supply in the first quarter of 1925, i. e. approximately 110 million dollars. very narrow, but according to Grabski, "we had to take the plunge, for although US$ 2.5 million is very little indeed ... there was no other way out"25 . This could certainly be interpreted that the alternative was the League scheme. The stabilization was successfully effected26 at a rate described as "correspond[ing] strictly to reality"27; as explained in Chapter 5, to stabilize at the market rate required less reserves to be sustained at least during its first moments. The real problem was to obtain reserves to maintain the peg for a prolonged period; this meant to promote some more "permanent" improvement in the country's external position so as to make the wage pressure that would follow the stabilization compatible with external balance. Indeed, as shown in Table 9-3, wages made very substancial gains with the stabilization, actually more than doubling in real terms between December of 1923 and February of 1924; correspondingly, real exchange rates suffered a marked deterioration during the first months of the stabilization. This would be partly compensated by increases in unemployment: the average number of unemployed workers in the last quarter of 1923 was 62 thousand; this was raised to 107, 110 and 157 thousand in the first three quarters of 192428. Even so the trade deficit suffered a continuous deterioration after the stabilization: during 1924 the quarterly trade balances were +11 , -65 , -51 and -107 million zloty, in the first two quarters of 1925 the deficits were raised to -179 and -240 million zloty respectively29.

25 Apud G. Zdziechowski(1925) p. 15. 26 And the hyperinflation was immediately stopped consequently. The weekly inflation rates, as expressed for the index of wholesale prices, beginning in the first week of January were 22.3%, 33.6%, 19.7%, 4.2% and -6.0%. As measured by the cost of living in Warsaw , the fortnighly inflation rates, starting in January were of 89.6%, 31.7% and -1.9%. Cf. E. Rose(1924) p. 26. 27 Ibid. p. 19 . 28 E. Wicker(1984) p. 5. 29 S. Starzynski (1927) p. 84. Table 9-3 Poland: real wages and real exchange rates during Grabski's stabilization (january 1914=100)

Date Real Wages1 Real Exchange Rates2 1923- November 56.0 81.1 55.1 83.4 December 44.0 95.0 79.7 103.7 1924- January 88.0 106.9 120.5 122.0 February 103.5 111.8 127.4 125.6 March 104.0 110.4 126.3 123.4 April 103.5 109.0 126.5 121.2 SOURCES and OBSERVATIONS: (1) Weighted average of 9 categories reported in ILO (1925) pp.115-116. (2) The first two series are from G. Zdziechowski (1925) p. 7 and correspond to wholesale and consumer prices in terms of gold, for January 1914=100. The third series is a wholesale price index with different coverage but expressed in terms of gold with the same series for exchange rates, from Republic of Poland (1926a) p. 321.

The key to the stabilization should be a "permanent" improvement in the country's payments position that could accommodate this deterioration in the current account. Although this was partly accomplished by the incorporation of Upper Silesia, the Poles seemed to see the reopening of international capital markets as the definitive solution to their problem. During the first semester of 1924 little could be done in this regard except by holding the currency stable by all possible means until the situation appeared settled enough to permit financial support to be obtained outside the League or without stringent conditionality. The government used three main weapons to pile up reserves during the critical first semester of 1924 : one was the domestic issue of indexed bonds in exchange for hard currency, the second was the domestic subscription of a new bank of issue and the third was the resort to foreign financial help through smaller loans floated outside the main financial centers and the accumulation of short-term commercial credits. On account of the first approximately US$ 5 million were placed during the first three months of 192430. As regards the new bank of issue, in March 31st subscriptions were closed and 99% of the nominal capital of 100 million zloty, or US$ 19.3 million, was subscribed in hard

30 These indexed bonds included a 5% "premium Dollar loan", indexed to the dollar, the 6% taxation bonds issued in antecipation of revenues, the10% railway loan and the 8% Treasury notes, all indexed to the zloty. The net issues were of 11.2 million zloty in January, 10.1 million in February and 4.7 million in March. Cf. E. Rose(1924) pp. 8-9, 14, Republic of Poland (1926b) pp.166-167 and G. Zdziechowski(1925) p. 19. currency with negligible foreign participation31; this was basically a way to capture private hoards of foreign currency. In March the Polish government contracted a loan of 400 millions lire, or around US$ 17.7 million, with the Banca Commercialle Italiana on the basis of the revenues of the state tabacco monopoly32. Though not very large it was certainly significant: the amount was little less than half of the League loan for Hungary. Despite the uncertainties involved, the loan was very successful in Italy being oversubscribed five times33; this had a very positive repercussion on the main financial centers34. In addition to that the Polish government managed to obtain from the French government a commercial credit of 400 million French francs, the equivalent to US$ 21.0 million, for the purchase of army supplies, from which no more of 1/4 of the total credit was actually drawn35. The contribution of all these operations accounts for most of the increase in reserves verified until the opening of the new bank of issue in June shown in Table 9-2 and the overall increase for 1924 shown in Table 9-4. During the second semester of 1924 reserves remained more or less constant around US$ 70 million despite the continuous worsening of the trade balance. It is interesting to observe that "unaccounted" capital outflows in 1923, which we can safely assume to correspond to "flights from the currency", summed about US$ 45 million. The return of these funds in 1924, which is indeed shown in the balance of payments figures as private short-term capital inflows, have certainly played a part , most likely in the second semester of 1924, in maintaining the stock of reserves stable in this period36. The hyperinflation was successfully stopped but more permanent solutions to the Polish payments problem seemed necessary.

31 E. Rose (1924) p. 21. 32 Only two tranches of the loan would be due in 1924: one of US$ 9.2 million was due in May and the another of US$ 2.7 million was due in November. Cf. Republic of Poland (1926b) pp.166-167. 33 In this respect it is significant that the loan paid 7% , and was issued at 89, conditions quite unfavorable for Poland yet attractive to investors. Cf. E. Rose (1924) pp. 14-15. 34 A Polish authority observed that "perhaps the greatest advantage derived from this loan" was that its success "enlightened foreign capital to the possibilities of investment in Poland" and added that the Polish "should remember this with gratitude". Cf. G. Zdziechowski (1925) pp. 21-22. 35 L. Czarnozyl(1930) p. 77 and M. A. Heilperin(1931) p.134 . 36 A significant contribution was also made by the indemnity paid by the Russians on account of the Peace of Riga ending the Polish-Soviet war in 1920. The indemnity summed to approximately 8 million dollars. Table 9-4 Poland: Balance of Payments, 1923-1926 (millions of zloty)

1923 1924 1925 1926f exportsa 1167.3 1219.9 1260.2 1259.9 imports 1116.6 1478.6 1602.8 896.2 trade balancea 50.7 -258.7 -342.6 363.7 current account 128.1 -215.0 -320.2 377.2 loans governmentb -11.4 68.9 205.8 -36.7 privatec 84.8 255.2 148.5 69.2 commercial credits - 43.7 -306.2 95.9 direct investmentd 31.1 70.7 58.9 17.1 total capital 103.5 438.5 107.0 143.2 change in reservese -39.8 194.5 -224.2 149.2 unaccounted -227.0 -2.2 43.0 -366.2 SOURCES and OBSERVATIONS: (a) Includes an adjustment for Dantzig trade. (b) Includes municipal loans of 0.3 million in 1924, 43.9 millions in 1925 and 6.3 millions in 1926. (c) Banks inclusive. Includes 5.0 millions of bills of the Bank of National Economy in 1925. (d) Includes also net sales of securities, net sales of real state and in 1924 includes 42.4 million relative to the Russian Indemnity established by the Riga Treaty. (e) Includes net outflows of bullion. (f) All values computed at the parity of 1923. For 1926 for which the original data is reported at the new parity we converted it at the old parity for the sake of comparison. From LN (1927) pp. 141-151 and (1928) pp. 180-190 and Bank of Poland (1930) pp. 95- 96.

9.4) The collapse of 1925

The external accounts were not helped but a liberal tariff policy initiated in the summer of 1924 and a bad grains crop in the fall37. It is fair to say that in the end of 1924 there was no more returning capital accruing from previous "flights" from the currency38, so that at this moment the Poles seemed to face very clearly the second round of their stabilization strategy: the hyperinflation had been stopped by pegging the exchange rate, but the ensuing wage pressure reduced (appreciated) the real exchange rate and now reserves seemed severely pressured. The basic problem of mantaining external balance at the desired level of real wages appeared to become threatening again.

37 F. Mlynarski (1926) pp. 40-45. 38 This can be seen, for instance in the sizeable reduction of short-term capital inflows on private account from 1924 to 1925. Cf. LN (1927) pp. 141-151.

The Polish authorities, Grabski in particular, seemed to perceive this to be the time to approach international capital markets again in order to accomplish a more "permanent" solution for their problem39; the stabilization was now one year old and reserves were high, so that Poland was in a position to negotiate a solution in favorable terms40. Again little help could be found in London, as the British still insisted upon the League alternative. The American capital market was much more receptive; the Poles managed to float a US$ 50 million loan under Dillon, Reid & Co. and most importantly, without any kind of conditionality. The loan resulted to be a failure, however; only half of the original issue could be placed which was attributed to the increased political tensions with Germany which created "a peculiarly disquieting atmosphere"41 that would escalated in June into a tariff war with serious consequences to Poland's trade42. More important than the loss in terms of the proceeds of the loan was the fact that it failed to reintroduce Poland to international capital markets or that it did not trigger the steady influx of foreign capital the Polish expected. The Bank of Poland started to loose reserves in a very fast pace from April of 1925 and despite the help of a number of international banks, including the Federal Reserve Bank of New York43, the intervention proved hopeless: reserves fell from the high mark of US$ 47.3 million in March to US$ 30.8 million in May, then to US$ 14.2 million in July and to US$ 7.2 million in September, to reach the level of -US$ 3.2 million in November. From August, when the zloty was allowed to float until June of 1926, when it was stabilized again , the zloty lost 42.5% of its value. The collapse of 1925 did not represent the return of the hyperinflation and in this sense it cannot be said to be a failure of the Grabski Plan; in fact the episode seemed like a post-1945 type devaluation under the Bretton Woods system. One possible explanation for that is related to the fact that many sliding scales clauses and indexation schemes had

39 M. A. Heilperin (1931) p. 134 . 40 Z. Landau & J. Tomaszewski(1984) p.279 and Z. Landau(1974) p. 289. 41 F. Mlynarski(1926) p. 48 . 42 C. Kruszewski(1943). This "war" consisted on sucessive import prohibitions and retaliatory moves from each side which affected 47% of German exports to Poland and 57% of Polish export to Germany. Poland was in a flagrant disadvantage, as the Polish prohibitions affected what corresponded only to 3% of the total exports of Germany while the German embargo affected 27% of total Polish exports. Cf. Z. Landau & J. Tomaszewski(1984) p. 281. Overall, however, the Polish managed to redirect her exports so as to avoid any sizeable fall in total exports. Cf. S. Starzynski (1927) pp. 84-85. 43 Z. Landau & J. Tomaszewski (1984) pp.282-283 and R. H. Meyer(1979) pp. 63-64. already been dropped from labor contracts at this point. Wages suffered a blow with the depreciation and this tighter fiscal and monetary policies produced very significant increases in unemployment. The wage restraint thus provoked limited the inflationary impact of the depreciation and produced consequently an improvement in competitiveness shown in Chart 9-1. This combined with the implementation of a very restrictive commercial policy produced a contraction of 44% in imports from 1925 to 192644. This sharp improvement in the current account could accommodate a sizeable "flight" from currency and even produce a significant increase in reserves as shown in Table 9-4.

Chart 10-1 Poland: real exchange rates, August 1924-May 1926

Mar.1925 140

130

120

110

100

Dec.1925

90 ago/24 set/24 out/24 nov/24 dez/24 jan/25 fev/25 mar/25 abr/25 mai/25 jun/25 jul/25 ago/25 set/25 out/25 nov/25 dez/25 jan/26 fev/26 mar/26 abr/26 mai/26 SOURCE: Wholesale prices in terms of gold from Republic of Poland (1927) p. 322.

Once more the Poles went to international capital markets for help; this time they approached Benjamin Strong, who had helped them in the attempt to prevent the depreciation of the zloty in 1925, and found a sympathetic ear for their endeavors to avoid the League alternative, at this point strongly insisted upon by the British45. At the same time, following advice from Dillon, Reid & Co. the Poles once more invited a

44 It should be mentioned that the tariff war against Germany helped the effort to curtail imports to the extent that imports from Germany were specially hit by the new Polish tariffs. Total imports from Germany reached 506 million zloty in 1924, representing 32.2% of Polish imports , and in 1926 they represented only 26.6% of total imports having fallen to 211 million zloty. Cf. S. Starzynski(1927) p. 92. foreign financial expert to report on Polish finances, this time the celebrated American professor Edwin W. Kemmerer from Princeton University, widely known as mentor of a number of currency reforms around the world, especially in Latin America46. Kemmerer reported on January 1926, but as it happened with other experts' reports on Poland , it had no apparent effect on policy. In May 1926 a coup d'état would bring to power charismatic leader marshal Pilsudski, but this would represent no discontinuity with respect to past economic policies, on the contrary, the new regime seemed still more determined in establishing a steady influx of foreign capital into Poland47. Pilsudski maintained a second invitation to Kemmerer, but the loan negotiations in New York again found a serious obstacle on the issue of "control" or conditionality48. But finally the Polish negotiators managed to explore the diversity of interests and mutual commitments of central bankers and the consequent difficulties of coordination of an international action in such a manner that they were able to sign a loan agreement in October of 1927 with very little and vague conditionality49. The agreement included a loan of US$ 62.0 million and £2.0 millions and also an emergency credit facility of US$ 20 million to be used in moments of pressure over the zloty50. After that, the stability of the zloty was not to be disturbed even by the 1931 crisis.

9.5) Summary and conclusions

Polish attitudes towards stabilization contrasted sharply with those of Austria and Hungary as regards both the priority given to investment expenditure and tolerance to stringent conditionality. It is difficult to judge whether or not the Poles did better than

45 R. H. Meyer(1970)pp. 69-73, L. Chandler (1958) p. 392 and H. Clay (1957) p. 259. 46 R. N. Seidel(1972) and P. W. Drake (1979). 47 Z. Landau(1977) p.180 and (1981) p. 177. 48 The Polish had extensive negociations with Bankers' Trust & Co. by with no practical result, according to Benjamin Strong "it having been found impossible by the Polish Government to agree to certain forms of financial control which the Banker's Trust Company desired to impose as a condition to the granting of such a loan ". Apud R. H. Meyer(1970) p. 68. 49 The loan agreement indeed prescribed a resident financial "advisor" and a system of periodical reports, though the advisor had actually very little power in influencing policy within Poland and no powers regarding the proceeds of the loan . For details see R. H. Meyer(1970), L. Chandler (1958) and H. Clay (1957). otherwise mostly because it is difficult to conceive the conterfactual scenario. It is true, for instance, that a second Michalski type stabilization attempt late in 1922, thus after the reincorporation of Upper Silesia, would imply in postponing most of the investment projects undertaken during this period; depending on how foreign finance reacted to that, these projects could remain on hold for a considerable period of time. On the other hand an earlier, and a more well behaved, stabilization would allow the Poles to enjoy more of the abundance of foreign capital observed during the second half of the 1920s. Foreign money markets seem to have gained confidence on the Poland as far as foreign direct investment was concerned only after the floating of the large stabilization loan late in 1927, thus almost at the end of the capital exports bonanza of the 1920s. Inflows of capital into Poland during 1927-1928 represented 30.1% of this period's total exports; for Hungary, which is the appropriate country for comparison, capital inflows reached 63.1% of exports in this same period51. In sum, there were rewards and penalties for "good behavior" and by no means the balance is clear for Poland. The "unaided" stabilization of 1924 used instruments to obtain hard currency that Austria and Hungary also used, like the floatation of indexed bonds domestically and the subscription of a new bank of issue. Two basic differences emerge; one was the financial help obtained from "secondary" financial centers and the other was the annexation of Upper Silesia. The French and the Italians did not have a smooth relationship with the British and the Americans during the 1920s as far as financial issues were concerned. The accounts are several on rivalries and disputes around areas of influence especially as regards spots left open by Germany52. The Poles perceived these intricacies and managed to use them to obtain moderate, though very important, help from Italy and France and to win the Americans to their cruzade against the British alternative through the League. No initiative of this sort is to be found in Austria and Hungary. But the most important "aid" to the stabilization came from Upper Silesia, whose annexation represented a "permanent" improvement in the country's external position that partly solved the incompatibility between the demands of the labor movement and the requirements of external balance. Thanks to Upper Silesia Grabski could sustain the

50 Details in J. F. Dulles(ed.)(1928). 51 See Table 2-1. On capital movements into Poland see L. Wellisz(1938). stabilization without much help from abroad, with a small stock of reserves and with expansionary, or at least non-contractionary, financial policies. Yet, Upper Silesia was not enough to accommodate the sharp increase in real wages, and the implied deterioration in competitiveness, that followed the stabilization. By stabilizing the exchanges at the market rate Grabski was establishing a level for real exchange rates that was too high at zero inflation, as discussed in Chapter 5. Inflation was a way to maintain wages below their targets, so that without inflation wages should quickly reach their desired levels. This happened during Michalski's plan and happened again with Grabski. In the former's case the already high trade deficit increased sharply and quickly, and reserves were soon depleted. For the latter, there was a trade surplus at the onset of the plan, the deficit took a few months to reach a sizeable magnitude and they counted on the foreign credits, the indexed bonds and on the subscription of the new bank to resist the pressure during the first semester of 1924. Returning funds, the Russian indemnity and commercial credits helped to hold the line after June, but unless some "permanent" solution was provided the collapse was inevitable. In fact the floating of the zloty in 1925 was not strictu sensu a collapse, it was the second round of the stabilization problem, the one of achieving external balance at wages closer to their targets. This time unemployment was sharply increased and such self- inflicted sacrifices finally opened the door of international capital markets to Poland. Most likely, however, it was too little and too late.

52 See for example D. Silverman (1982) F. Costigliola (1977).

Chapter 10

The rentenmark miracle and the German stabilization 10.1) Introduction

The German inflation, though by no means the biggest ever1, was hailed by Lionel Robbins as "the most colossal thing of its kind in history"2; and at least as judged by the incredibly vast amount of research devoted to the episode, the very same applies to the end of the German inflation. The German stabilization is one of the most challenging and most discussed episodes of this sort. It is often referred to as a "miracle"3, which is somewhat indicative that the episode has not yet been fully understood, especially as far as the nature and workings of the monetary experiment represented by the rentenmark is concerned. This chapter attempts to offer a modest addition in this regard. Previous chapters have provided important pieces of the German stabilization puzzle. The advancement of indexation and dollarization was discussed in Chapter 6. The nature of the fundamental external "imbalances" involved, namely the payment of reparations, the difficulties posed by the decisive commitment of the German labor movement in recovering the pre-war levels of real wages, and the solution for the problem provided by the Dawes Plan were examined in Chapter 3. Finally, Chapters 4 and 7 provided a case against inflationary finance as a determinant of the hyperinflation and also against the notion of fiscal "reforms" as the key to stabilization. Like in the other cases the missing step is the process by which the exchange rate was fixed, and especially how this could be accomplished much before the solution of the fundamental "imbalance" was even visible. There are all sorts of myths and misunderstandings about the German stabilization, some related to fiscal policy - that we hope to have dismissed in Chapter 7 - but most of which referring to the role played by the rentenmark experiment. Indeed, no adequate explanation has ever been offered for the German public to accept the rentenmark as a "stable-valued" currency in November of 1923. Traditionally this alleged "miracle" is associated to a limit imposed on the total rentenmark issue which would force the

1 In terms of monthly inflation rates at the peak , the German inflation ranks 3th behind the Hungarian and the Greek episodes of 1944 , cf. P. Cagan (1956) p. 26 . 2 C. Bresciani-Turroni "The Economics of Inflation: a study of currency depreciation in post-war Germany"(London, 1937) p. 5. 3 3 The term has been used by many authors, for example G. Stolper "The German Economy, 1870-1940, Issues and Trends" (New York, 1940) p.164 and C. Bresciani-Turroni, The Economics of Inflation, p. 336. government to live "within its own means"; this would characterize what has been called a "regime change"4. It is not often observed, however, that such limit was not binding as the rentenmark had a fixed exchange rate with the ordinary Reichsbank notes that were neither demonetized nor subject to any limit by the reform. An explanation for this old enigma is therefore very clearly lacking. This chapter will attempt to provide this explanation, along with some indispensable elements for a comprehensive explanation for the German stabilization. The basis for this explanation is to be found in the extraordinary advancement of indexation, its further degeneration into a process of "dollarization", and on the monetary innovations generated during the hyperinflation period. These developments are reviewed in the next two sections, which also offer a detailed account of the experience with the "stable-valued" monies and their possible bearing to the inflationary explosion observed after June of 1923. With the stage thus set, section 10.4 discusses more specifically the mechanism that made the rentenmark a "stable" currency", and also the process by which its introduction permitted the pegging of the exchange rate. Section 10.5 examines the existing views on the rentenmark mechanism and its role to the German stabilization. The next section discusses mostly the problem of sustaining the exchange rate fixed during the few months before the reparations issue was given a solution by the Dawes Plan. Quite like in the other cases, real wages quickly regained pre-war levels after the stabilization, thus determining a sharp deterioration in competitiveness and an equally sharp increase in the current account deficit.

10.2) The "stable valued" monies

It is commonly observed that high inflations destroy the function of the national money, but it is less often observed that the unit of account function is also weakened, as the monetary unit becomes inappropriate for reckoning real values. The systematic publication of prices indexes transforms the way the national money performs

4Especially T. Sargent "The Ends of Four Big Inflations" in R. Hall(ed.) "Inflation, Its Causes and Effects" (Chicago, 1982) p. 83 and K. L. Holtfrerich "Germany and Other European Countries in the 1920s" in J. Williamson (ed.) "Inflation and Indexation: Argentina, Brazil, and Israel" (Washington, 1985) p. 134. the unit of account function, as payments start to be reckoned in terms of the index, and no longer in terms of the standard monetary unit. With the dissemination of the practice of stipulating prices, wages and payments according to one standard - dollars, Swiss francs or some price index - but the actual payments being made with the depreciated national money, what basically happens is that indexation is performing a monetary function. That indexation involved the "principle of the dissociation of the two functions of money, as a standard of value and as a ", as observed by a contemporary report on wage indexation5, was the key to the monetary innovations introduced during the hyperinflations. Price indexes and "imaginary currencies" like the Polish Zloty in 1923 or the pre-war metallic units, worked like "money of accounts" for they were "money" only to the extent that they performed the unit of account function . The Polish Zloty was introduced during the summer of 1923 to be used in the assessment of taxes wherever they involved valuations and was generally adopted as an unit of account. It is interesting to observe that notes could be issued corresponding to these "monies" (zloty notes, for example) and in this circumstance the problem would become one of securing value for these notes. As "promises to pay" they could be backed 100%, or up to an acceptable cover ratio, by gold. But nothing necessarily implies that these "promises" or "debts" should be redeemable in gold; it is the very principle of fiduciary currencies that the truly important aspect of these "debts" is that they should be repaid in purchasing power over independently of the "convertibility" aspect or of the means of payment with which the "debt" is "repaid". Even if the "debt" is not repaid or redeemable in gold the "promise to pay" might be sound so long as the same purchasing power implied by full convertibility is surrendered at redemption; it might even be the case of the redemption be made using paper currency. That means basically that an indexed debt is as good as a debt repayable using the good whose price is taken as the index. That implies, for instance, that, if the real exchange rate is constant, indexed bonds should have constant gold prices. If these bonds, for some reason assume monetary properties, such as to serve as means of payment, these indexed monies should have a constant exchange rate

5 ILO (1925) p. 74. 6 The Polish zloty was introduced in mid 1923 but was only fully "monetized", in the sense of having Zloty notes issued, in 1924. with gold. These were the basic principles on which, for instance, the Hungarian sparkrone, or the "thrift crown", introduced in February of 1924 was based. Like the zloty, the sparkrone was also a "money of account" but it would also be used for the assessment of taxes (also with insignificant effects) and most importantly accounts in sparkrone could be opened in the Hungarian Note Institute . The experiment lasted very little and no indication could be found that more ambitious schemes of monetary reform were under consideration. The negotiations with the League were very advanced at this point so that it appeared that the idea was to relieve some of the pressure on the exchanges until the floatation of the reconstruction loan by offering an alternative to foreign currencies. The scheme worked fairly well while it lasted, which stimulated Hungarians to repeat the experiment in 1946 during their second hyperinflation . It would be in Germany, though, that monetary experimentation would advance towards real innovation. Several types of private and semi-official issues of money could be observed during the hyperinflation. In 1922 a private rye rentes bank (Roggenrentebank) was founded; it issued its first bill of exchange denominated in pounds of rye in December of 1922 . In the beginning of 1923 several public bodies - cities, states and public ' companies - started to issue loans denominated in commodities such as rye, coal, and others as shown in Table 10-1, but priced and serviced in marks according to the current commodity prices .

Table 10-1 Germany: Material values loans, 1922-1923 (as quoted in the Frankfurt Gazzette at August 12th 1923)

Number Issuing body Commodity Total dollar value Subscription datec

1 Roggenrentenbank rye series I 400.000 Dec.30th,1922 series II 400.000 Feb.5th series IIIa 400.000 April 25th

7 L. L. Ecker-Rácz (1933b) p. 472. 8 See W. A. Bomberger & G. E. Makinen (1983) and especially B. Nogaro (1948). 9 H. Schacht(1927) p. 78. See Table 6-1 . In July 1922 the government had passed legislation authorizing and regulating the issue of these privately issued monies known as "emergency monies" or notgeld. Cf. Republic of Germany (1924) p. 67.

series IIIb 130.000 May 5th series IV 114.000 June 7th 2 Oldenburg State Bank rye 220.000 June 1st 3 State of Macklemburg rye series I 50.000 Dec 31st,1922 series II 70.000 May 24th 4 Prussian State rye series I 230.000 May 18th series II 244.000 May 25th 5 State of Anhalt rye 40.000 April 23th 6 City of Berlin rye 53.000 June 16th 7 City of Dresden rye 32.000 July 18th 8 City of Gottingen rye 10.000 July 1st 9 City of Bernburg rye 4.900 Mar.23th 10 State of Saxony rye 500.000 June 28th 11 District of Sandershaausen rye 70.000 Mar.31st 12 Thuringian Evangelical Church rye 30.000 Mar.31st 13 Anhalt Evangelical Church rye 18.000 Mar.26th 14 City of Hannover wheat 30.000 June 18th 15 City of Aschorsleben wheat 12.000 April 23th 16 Badenwerk coal series I 650.000 Feb.10th series II 650.000 Mar.10th 17 Grosskrafwerk Mannhein coal 420.000 Feb.13th 18 State of Westphal coal series I 490.000 May 12th series II 490.000 June 23rd 19 City of Breslau coal 240.000 April 20th 20 City of Zwickau coal 100.000 Mar.5th 21 State of Saxony lignite series I 500.000 Feb.10th series II 500.000 Mar.10th 22 State of Hessen lignite 65.000 April 15th 23 Badenbürgishe Kreis Elekt. lignite 120.000 Mar.17th 24 Mitteldeútschland-Cassel Elekt. lignite 350.000 Feb. 25 Stadtischenlicht Wasserwerke coke series I n.a. Feb.15th series II n.a. Feb.28th 26 City of Goppingeen coke n.a. n.a. 27 Prussian State potash series I 230.000 May 14th series II 520.000 May 25th series III 520.000 June 12th 28 Rheniland-Main-Donau gold 500.000 April 18th 29 Neckar gold 250.000 May 30 Suddeútsche Fesvertband Stüttgart gold 365.000 July 7th 31 Schleswig-Holsteinische Elektrizit. gold 66.500 n.a. 32 Bayer Grosskraftwerke gold n.a. June 20th 33 State of Hamburg sterling 4.326.500a August 34 City of Lübek Swed.Crown 530 312b October

TOTAL 14.741.212 SOURCE and OBSERVATIONS: (a)Converted in dollars at the rate of 4.3265 to the pound. (b)Converted at the rate of 3.7744 Swedish crowns to the dollar. (c)1923 unless otherwise stated. Compiled from data from J. M. Robert(1926) pp.94-104 .

These "loan" notes were made in small denominations so as to circulate as means of payment which was actually their main purpose. The Oldenburg issue in Table 10-1, for example, would be of bonds priced in marks at the equivalent to 125 kg of rye and redeemable in four years at the marks equivalent of 150 kg of rye, which meant a "own" rate of interest of 5% a year payable at redemption . Along the same line the company supplying the province of Baden with electricity issued its "coal value loan" in bonds equivalent to 1/2, 1, 2, 5 and 10 tons of coal serviced and redeemed in marks according to the average price of coal observed in the 6 months preceding the payment . Similar issues followed: several other "commodity" loans were issued by the most various of bodies and a variety of other commodities - e. g. wheat, potash, lignite, sugar, beer and even kilowatts - were used for backing, or what was in fact indexing, "stable value" loans . The value of these bonds remained stable for no other reason than the fact that holding these notes was equivalent to holding commodities with stable dollar prices often quoted in international markets. But the important fact was that these notes were not really convertible in the commodities of reference. In fact the commodities served only to provide a price index to which the notes were pegged, the payments were actually made in depreciated marks at the current quotation of the commodity. In fact these loans represented a very interesting class of indexed bond, not only in view of the type of price index used but mainly because their small denominations gave them functions of a means of payment. Being reserves of value and means of payments these loans circulated as unrestrictedly as money but with the important feature of being "stable-valued". The experiment, according to Schacht, "spontaneously evolved by the natural course of events"; these loans "enjoyed great popularity, unaffected by the fluctuations in the prices of commodities concerned, and the practice of expressing the values in terms of commodities had a long vogue" .

7 K. Helfferich (1927) p. 509. 8 Ibid. p. 510. 9 H. Schacht (1927) p. 78, J. M. Robert(1926) p. 101 and R. R. Kuczynski(1923) p. 764. 10 H. Schacht (1927) p. 78.

10.3) Official "stable valued" monies and inflationary explosion

The government was attentive to the development of private "stable valued" monies and perceived the opportunity of using the experience to help the support of the exchange rate initiated in March in connection with the passive resistance at the Ruhr . In an attempt to stem the outflow of reserves, the government decided to issue a dollar denominated "stable valued" loan, i. e. a dollar indexed bond, with the purpose of securing foreign exchange for the continued support of the mark . This gold loan represented an advance over the "material value loans" of the last section as it would be indexed to the dollar; indexation to the dollar was chosen so that it would be reserve of value and means of payment like the others, but would employ a much less confusing and already widely used unit of account. These notes appeared to have all characteristics of money in addition to being "stable valued" or wertbeständiges. Yet, the government seemed to misunderstand the causes of the popularity of the wertbeständiges loans, and issued the loan in large denominations which rendered it unsuitable for means-of-payments functions. The loan was actually considered a failure for it could not provide a sizable increase in international reserves: only one half of the total issue of US$ 50 million was subscribed immediately and the stock of reserves at this point stood around US$ 240 million. Yet the notgeld law authorized banks to issue their own wertbeständiges currencies against deposit of such bonds, so that to the extent that the subscribing banks did make issues the loan would have fulfilled its functions. In August, the government decided to repeat the experience but this time the purpose was not to obtain foreign currency to support the mark but was very close to the idea of monetary reform . The new "loan" had denominations as low as 1/10, 1/4, 1/2, 1, 2 and 5 dollars, in addition to the ordinary large denominations. The total issue was of

11 Parallel to the strategy of passive resistance, the German government had decided to employ the hitherto untouched Reichsbank reserve to stabilize the exchanges. The move appeared to be an attempt to further wear down the French initiative and possibly win the British, who had been insisting on the Reichsbank using its reserve to check the depreciation for quite some time. Cf. C. Maier(1975) p. 366. 12 See Republic of Germany (1924) p. 72. 13 According to Havenstein quoted by C. Maier (1975) p. 367. 14 The loan was issued on August 14th; and by this time Helfferich's plan of monetary reform, which would later be put into operation , had already been offered to Cuno's attention. Cf. J. G. Williamson(1971) pp. 386- approximately US$ 120 million, an amount nearly as large as the gold value of the outstanding Reichsbank notes at this point . Around US$ 72 millions of the total issue corresponded to subscriptions of small denominations . Shortly thereafter the Railway system issued a "stable-value" loan of approximately US$ 40 million guaranteed by a deposit of the gold loans or of a Gold Treasury Bond especially created to serve as backing for wertbeständiges currencies . These official issues would have extraordinary consequences as regards the composition of the money supply and the dynamics of inflation. The composition of the money supply, broadly understood as the collection of all monetary assets with means of payment properties, is shown in Table 10-2. Private wertbeständiges experienced a tremendous "boom" after the official issues but there is little information on the amounts in circulation by the end of 1923. Table 10-2 considered the total value of US$ 14.7 million reported in Table 10-1 and an ad-hoc estimate of US$ 30 million for December. The amounts reported for gold loans and the railway issue show a sharp increase as a substantial part of the subscriptions - actually their final installments - were made during this period. The amount of foreign currencies in circulation reported in the table is an estimate based on the following: German historian C. L. Holtfrerich estimated it as between US$ 476 million and US$ 715 million and Bresciani-Turroni established somewhat wider bands at US$ 120 million and US$ 950 million . According to the balance of payments figures available an amount of approximately 286 million dollars of foreign banknotes was "exported" during 1924 and 1925 . This certainly accounted for a substantial portion of the stock of foreign currencies hoarded or in circulation in Germany by the end of 1923. Most likely a comparable portion of these hoards appeared in the balance of payments statistics as "unaccounted" inflows, which totaled 176 million dollars in 1925 . For the purpose of Table 10-2 a conservative estimate of US$ 450 million was adopted. Lastly, Table 10-2 includes rentenmarks as stable-currencies, which will be

387 and K. Helfferich (1924b). 15 In July, the gold value of the outstanding Reichsbank note issue was 131 million dollars. Cf. J. P. Young(1925) vol. I pp. 537-538. 16 See Republic of Germany (1924) pp. 57 and 72. 20 Ibid. p. 68 17 C. L. Holtfrerich (1985) p. 125 and C. Bresciani-Turroni (1937) p. 345. See also H. Schacht (1927) p. 106 and W. Baumgartner (1925) p. 95. 18 Table 10-5. explained below.

Table 10-2 Germany: Proximate composition of the money supply , November/December of 1923 (millions of dollars)

November 15th December 15th Private wertbeständiges 14.7 30.0 Gold loan notes3 65.6 113.0 Railway stable valued notes 2.4 33.8 Foreign currencies2 440.0 440.0 Rentenmarks2 - 199.4

Stable currencies total 522.7 816.6 Regular currency3,4 41.2 125.8

TOTAL 563.9 942.4 SOURCES and OBSERVATIONS: (1) From Table 10-1. (2) Estimates, see text. (3) From Republic of Germany (1924) p.20. (4) Includes Reichsbank notes and legal non-stable notgeld.

A remarkable fact documented in Table 10-2 is the insignificance of the circulation regular "non-stable" currencies by the time of the stabilization. If money substitutes were said not to allow the elimination of the paper-mark in 1922 , by the fall of 1923, after the August gold loan Schacht argued that "the Reich may be said officially to have abandoned the paper mark" . The dissemination of stable monies, in conjunction with the remarkable increase in the amount of foreign currencies in circulation, resulted in a decisive blow in the "moneyness" of the national money as its means of payments function, the only one it retained at that point, was destroyed by the "stable valued" currencies . The consequences of this "abandonment" of the mark as regards the dynamics of inflation are by all means

19 Ibid idem. 20 R. R. Kuczynski (1923) pp. 768-769.

21 H. Schacht(1927) p. 77. The dissemination of "stable value" currencies such as Wertbeständiges , foreign currencies, and metallic coins seems to provide an alternative explanation for the rise in real money balances detected by P. Cagan (1955) and R. Flood and P. Garber (1980), which they attributed to "rumors of monetary reform". Cf. Cagan(1955) p. 56. It is true that there were rumors of monetary reform and actually more than that as the governments intentions to undertake a currency reform became very clear to the public much before it came into being. The question is whether this would make anybody any more prone to hold nominal balances while inflation was running at such wild levels. 22 J. Robinson(1938) p. 512 and J. M. Keynes (1923) p. 50. extraordinary, as shown in Table 10-3:

Table 10-3 Germany: Inflation rates, January-November,1923 (% per month) month CPI Wholesale Ex. rates January-March† 69 59 49 April-June† 44 67 81 June 100 132 137 July 395 221 285 August 1,459 1,208 1,162 September 2,46 2,035 2,432 October 24,28 24,432 29,607 November 17,865 8,6 10,121

† averages for the quarter. Source: C. L. Holtfrerich (1986) pp. 24-33.

The table shows a decisive twist in the evolution of the German inflation after June, when it seems to enter an "explosive" trajectory. That coincides with the dissemination of "indexed monies", and seems to be reinforced by the second government internal loan in August. Of course, this meant an important change in the nature of the inflationary process; the "explosion" is not to be described by the model of Chapter 5, that was seen to explain fairly well the evolution of the German inflation up to then. The inflationary explosion occurs as the marks ceases to be the only means of payment available, so that agents would only accept payments in marks at sky-rocketing premia. The mark becomes a "hot ", and the exploding inflation rates reflect simply the "lethal" shock on the demand for marks - which presumably had reached a minimum in the spring of 1923 - represented by the dissemination of indexed monies.

10.4) The Rentenmark mechanism

The incredible dimensions of the price inflation observed in the Summer of 1923 after the dissemination of "stable valued" currencies and the perspective of complete economic collapse of the Reich forced the German government to consider what appeared then a seemingly hopeless stabilization attempt without a settlement of the reparations issue . The proposals discussed in the late summer and early fall of 1923 bore no relation with the negotiations that started later on and would lead to the Dawes loan late in 1924; the alternatives discussed then were basically "unaided" ones. There was a number of ideas under consideration, most of which hinging on the establishment of a new gold backed currency, such as those of socialist theorist Rudolf Hilferding, banker Hjalmar Schacht, the Federation of Industries and State Secretary Julius Hirsch, among others . An obviously decisive handicap to all of them was the very reduced stock of divisen at the Reichsbank, and the fact that a foreign subscription of a new bank of issue, as much as a domestic one, even if mandatory, were both regarded as unfeasible . One important point to observe as regards Germany was that reserves were never depleted, much to the contrary, so that at some points the real value of the money stock fell as low as to reach values for which the cover ratio was very close to 100%. In the late summer of 1922, for example, the Reichsbank reserve stood at US$ 220 million and the real value of the money supply had been reduced to approximately the same value . Similarly in July of 1923 the real value of Reichsbank notes in circulation was estimated to be approximately US$ 130 million while international reserves were worth about US$ 120 million . Yet in both occasions the real value of the money supply was very small compared to the stable prices demand for money; considering the money stock observed during 1925-26, for instance, the cover ratios assured by existing reserves at these moments would be 17.5% and 9.5% . These values would be too small to assure a gold convertibility in normal conditions, or under stable prices; but as observed by many authors, including Keynes and Bresciani-Turroni , the government could declare convertibility at a fixed

23 J. M. Keynes (1923) p. 50. 24 In this respect Helfferich argued in February 1924 that "we had to try the experiment without being able to wait either for an amelioration of the general economic and political conditions or for a solution of the Reparations problem ... although such a reconstruction and solution form the condition sine qua non for a permanent salvation of our monetary system". He added that "the experiment that has been realized in the Rentenbank is an enterprise of deadly risk; it is a jump over a precipice, the opposite ledge being veiled in clouds." C. Helfferich (1924a) p.261. 25 See C. L. Holtfrerich (1985) p. 129, V. D'Abernon (1927) p. 24, H. Schacht (1927) p. 82 passim and W. Baumgartner (1925) pp.16-19. 30See W. Baumgartner (1925) pp.16-19.

26 J. P. Young (1925) vol. I p. 537 and Republic of Germany (1924) p. 65. See also C. Maier (1975) p. 296 27 J. P. Young (1925) vol. I , p. 538 and Republic of Germany (1924) p. 65. 28 Considering the average money supply of 1260 million dollars. 29 J. M. Keynes (1923) pp. 46-47 and C. Bresciani-Turroni (1937) p. 346. exchange rate, thus stopping the hyperinflation, and sustain it at least for a short period of time. Experience would show, though, that such period of time was indeed very short, for in a couple of months the cover ratio had already fallen to unsustainable levels . Besides, the failure of the exchange rate stabilization attempt enforced simultaneously with passive resistance at the Ruhr had convinced the German authorities that gold reserves were not enough to sustain a continued intervention to support the mark without additional sources of foreign exchange. These arguments, and in particular the notion that a 100% gold convertible currency would allow a total issue regarded as insignificant and unsustainable in view of the probable "needs of trade" following the stabilization , were instrumental to defeat Hilferding's proposal of creating a gold department at the Reichsbank . The available alternative was actually quite unusual. Helfferich's proposal of a new currency indexed, but not convertible, to rye was basically a development or an extension of the experience with the "material value" loans and the gold loans described in the last two sections. The idea was that the several distinguished representatives of Germany's agriculture, industry and commerce, would be obliged to subscribe a new bank of issue; and the subscription would be made in paper marks, and in this respect it differed very fundamentally from the founding of banks of issue in Austria, Hungary and Poland, where the subscription was an attempt to capture gold hoards. The participation of each group of subscribers in the new bank would be proportional to its respective wealth or property and a mortgage on such wealth would serve as a guaranty against the failure of the new institution. This is nothing more than usual for companies of unlimited responsibility; by no means the new institution was meant to be an incarnation of the German national wealth as it seemed to be the popular view. This might have been an useful notion for public relation purposes, but had no economic basis whatsoever.

30 It is interesting to observe that if we consider only the ordinary Reichsbank notes and the alleged "paper" issue of rentenmarks in December, the gold cover ratio, that had been nearly 100% in the end of November, had already been reduced to 28% (ignoring the probable reserve losses of December that are not reported in the Reichsbank returns, though admited by Schacht (1927) p. 129 in the end of December. 31 The legendary reluctance of German officials, Havenstein in particular, in committing the Reichsbank reserves to stabilization attempts becomes thus understandable. Besides, a strong reserve position represented a strong bargaining instrument in the reparations-stabilization imbroglio, so much that Havenstein once referred to using the reserve for less than a definitive stabilization effort as "cutting Samson's hair", as quoted by C. Maier (1975) p. 297. 32 J. G. Williamson (1971) p.390.

This new institution's main task would be to issue a mortgage bond indexed to rye prices (rentenbriefe), in the same fashion as the other "material values" wertbeständiges loans and gold loans were issued. A significant difference would be that instead of issuing the bonds in small denominations to circulate as means of payments, the proposal suggested the issuance of notes called roggenmarks, in small denominations so as to become means of payment, but also 100% convertible on the rye indexed bonds. The proposed roggenmarks would therefore be a "stable valued" currency by the same, at this point widely known, mechanism that made the several other "material values" loans "stable valued", examined in detail in the last two sections . It was ingenious, though certainly not conventional, and the success of the wertbeständiges loans together with the unfeasibility of the other alternatives made it very appealing. So much that in the early days of August the Cuno government, and especially its finance minister Luther, was quite willing to implement the plan . The Cabinet fell, however, and the Minister of Finance of the Stresemann's cabinet, Rudolf Hilferding, was frankly hostile to the idea . Hans Luther, now minister of food, brought the plan to Stresemann's attention, and the project slowly gained ground; even before Hilferding was replaced by Luther the plan had been accepted. The only significant amendment to the project was that instead of rye as an index for the rentenbriefes, gold was to be used. After all the new currency was not to be convertible in rye but only pegged or indexed to rye prices, so there was no reason not to index it to gold which was superior as a price index . In light of this change the notes backed by the indexed bonds had their name changed to rentenmarks, and in November 15th the especially empowered government issued the

33 See W. Baumgartner (1925) pp.24-36; H. Schacht (1927), p. 80 and A. Fourgeaud (1926) pp. 199-201 passim. 34 K. Helfferich (1925a and b). 35 Hilferding considered the plan a "theoretical monstruosity", cf. J. G. Williamson(1971) p. 390. According to Hilferding money took its value from the labor required to produce it, so that to have value at all money had to be convertible on some substance having "intrinsic value", such as gold. That this made him a "rather old-fashioned" metallist was observed by H. Ellis (1934) pp. 93-101. It was also observed by Schumpeter and even by Lenin, W. A. Darity Jr & B. L. Horn (1985) p. 365. It is somewhat paradoxical that in this debate that socialists endorsed Hilferding's reactionary views on money and the innovative view was authored by a distinguished politician of the right. On this paradoxical monetary conservativeness of the left see C. P. Kindleberger (1984) p. 327. 36 Schacht observed that indexing with respect to rye "was calculated in a masterly manner to appeal to the psychology of the agricultural community", on whose political support the government depended. H. Schacht (1927), pp. 85-87. It was more than that however. Rye indexing assured that the "contribution" from agriculturalists to the Rentenbank would be indexed to the same prices relevant to the determination of the monetary reform decree. From the beginning, the new currency enjoyed a very high demand. Schacht reported that the public was "anxious" to exchange his paper-marks into rentenmark and that "in the first few days of the rentenmark issue long queues, stretching out into the street, were formed where the notes were being issued" . The public seemed to be well aware that the rentenmark had a fixed parity to the dollar, which followed from it being a wertbeständiges or a "stable valued" currency as many others already in circulation, and enthusiastically accepted it as such. The introduction of the rentenmark appeared to the public like the introduction of another gold loan; in this respect it is interesting to note that after the new law was passed there would still be a month delay until the rentenmark notes would be ready for distribution, and during this period the government did issue another gold loan to bridge the gap and, like for the other gold loans, the public's reaction was very positive . Two important provisions would make the rentenmark issue much more than simply the issue of another, though very large, gold loan. First, it seemed implicit that the old paper mark would be demonetized at some uncertain point in the future, but its issuance was not to be interrupted until much later. In this manner the rentenmark and the old paper mark would coexist in circulation and there would be nothing to prevent the old mark from depreciating with respect to the rentenmark the same way it was depreciating with respect to the dollar and to the other "stable valued" currencies. The introduction of the rentenmark , or the fact that the public saw it as a "stable valued" currency, allowed the authorities an opportunity for the fixing of the exchange rate. The second fundamental feature of the rentenmark experiment was that the exchange rate between the old paper mark and the rentenmark was fixed at the convenient rate of a trillion to one. It should be clear that this was by all means equivalent to fixing the exchange rate between old paper marks and the dollar as illustrated by the diagram .

agrarians income, thus preventing possibly sweeping windfall gains or losses. 37 Although most people were eager to get rid of its old marks, even some devisen were offered in exchange for the new currency, H. Schacht (1927), p.99. 38 Republic of Germany (1924) p. 72.

39 This mechanism is explained by Schacht in a similar fashion, ibid. pp. 114-115.

Diagram 10.1: The rentenmark mechanism

As rentenmarks started to be issued on November 15th, the government acted in two fronts: given that the wertbeständiges mechanism warranted that one rentenmark was exchanged for 10/42 dollars, as shown in the diagram by the continuous arrow, the government simultaneously exchanged rentenmarks against old paper marks at the rate of a trillion to one; simultaneously it employed its international reserves to intervene in the foreign exchange market and sustain the rate of 4.2 trillion paper marks to the dollar . It is important to note that since the rentenmark was a "stable-valued currency, its issuance could be seen as equivalent to a sale of indexed bonds with means of payments properties or more simply as an external loan. Yet small external loans could very well be insufficient to secure currency stabilization for obvious reasons; similarly a total issue that was too high could become problematic. The total authorized issue was limited to US$ 762 million; this amount, if added to the stock of international reserves in November of 1923 would sum US$ 870 million, which would provide a "cover" of stable currencies for approximately 70% of the stable prices demand for money as measured by the 1926-27 average value of US$ 1,260 million dollars. The rentenmark "loan" was then very substantial, even when compared to stabilization loans floated by other countries. It was not as big as the Austrian loan floated under the League of Nations auspices, which represented more than 100% of the stable prices demand for money; but it was bigger than the Hungarian one, which represented less than 50 % of the value of the stable prices money demand. In sum, as a result of this twofold attack - the use of the international reserves and the distribution of rentenmark - the exchange rate was stabilized; as indexation transmitted it to domestic prices inflation was stopped in one stroke.

10.5) Alternative interpretations of the rentenmark experiment

The rentenmark experiment marks one of the most extraordinary monetary experiments of all time, yet most historians of the episode seem to have misunderstood the mechanism and its role to the stabilization. Bresciani-Turroni, for example, argued that there was no reason for the "stable value loans" to have a stable value because their guarantees were "purely fictitious...[b]eing mere paper without any cover". With respect to the gold loans he argued that "the public allowed itself to be hypnotized by the word wertbeständiges written on the new paper money" . He argued further that the rentenmark was an inconvertible paper currency like the old paper mark only with a different name , a point which is basically endorsed by Thomas Sargent; according to Sargent "while great psychological significance has sometimes been assigned to this unit change, it is difficult to attribute any substantial effects to what was in itself only a cosmetic measure" . Other authors, even the non-monetarists, have put forth similar analyses: Angell referred to the rentenmark as a "confidence trick" . For Stolper it was a "psychological device" and for Graham "nothing more than a new tenor of inconvertible paper" . More recently Karl Hardach argued that the "backing" for the rentenmark notes were "fictitious", though it was enough to generate the "desired psychological effect" . Steven B. Webb termed it a "fable" . Rudiger Dornbusch too, in a recent paper, does not offer any explanation for the public's acceptance of the gold loan as hard currency despite it having "no backing", but

40Ibid. p. 112. 41 C. Bresciani-Turroni (1937) p.344. 42Ibid. p. 348. 43 T. Sargent (1982) pp.82-83. This diagnostic is fully endorsed by German historian C. L. Holtfrerich (1985) p.134. 44 J. Angell (1932) p. 24. 45Apud F. Ringer(1969) p. 86. 46 Frank Graham (1930) p. 12. 47 K. Hardach (1980) p. 29. 48 S. B. Webb (1985) p. 18. concedes that the rentenmark was stable-valued because it was convertible 1:1 on the gold loan . Even Gerald Merkin, who suggested that inflation had been stopped with the fixing of the exchange rate through the dollarization mechanism, argued that the rentenmark was "psychologically an advantage", the "real act of stabilization [b]eing the intervention of the Reichsbank in the foreign exchange market" . Most observers of the phenomena thus have emphasized the pathological aspect of the rentenmark not being convertible to or backed by gold. Indeed, an interesting element of continuity between old and new monetarist interpretations to the "miracle" can be found in the continuous search for a "backing" for the rentenmark which would justify it having value at all. It is commonly argued that its only "real" backing was the mortgaged property of the Rentenbank's subscribers and recalled that the disastrous experiences of the Assignats and of John Law's Banque Royalle notes was a lively reminder that the rentenmark system assured no real backing for the new currency . It was also argued, however, that even an unbacked "paper" currency could maintain a fixed relation with gold or other currencies if sufficiently limited in quantity, which was actually what many authors presented as an explanation for the "miracle of the rentenmark ": the public accepted it at a fixed relation with the dollar because its issue was fixed in quantity, or at least because it would force the government to live within its means. The more sophisticated form of this argument is unquestionably its more recent rational expectations version, according to which the real "backing" for inconvertible currencies, and even gold currencies under fractionary reserves, would be the present value of current and future government surpluses or the government's capacity to "make good on its debt" . This "backing" obviously depended on the "fiscal policy regime" followed by the government and "the public's perception of the fiscal regime, he argues, influenced the value of government's debt through private agents' expectations about the present value of the revenue streams backing that debt" . A change in the "fiscal policy regime" - which

49 R. Dornbusch (1985) pp. 9-10. 50 G. Merkin (1982) p. 46. 51 See for example C. P. Kindleberger(1984) p. 326; H. Schacht (1927), p. 85; J. P. Young (1925) vol.I p.426; A. Fourgeaud (1926) p. 202; V. D'Abernon(1927) p.36 and F. Graham (1930) p.12ff.16. 52 T. Sargent(1982) p. 45. 53 Ibid. p. 46. Note, in this connection that according to Sargent the difference between the wild money growth experienced before the stabilization and the slightly less wild one verified afterwards was that the former was "unbacked" and thus inflationary, while the latter was "backed" so did not disturb price stability. would be determined by a limit imposed on the government access to the printing presses - would be like creating a backing for the currency, so that the announcement of such change would exhert such a powerful influence on the public expectations as to bring about the abrupt end of the hyperinflation. Two observations should be made about this "limited issue" or "regime change" argument. First, given that the exchange rate between rentenmark and old marks was fixed, any limit on the rentenmark issue would be meaningless without a corresponding limit on the issue of old "paper" marks. In fact, there was no limit on the Reichsbank note issue on the basis of discounting private commercial bills, which actually nearly tripled during 1924. No "bullionist", or their modern monetarist successors, would ever concede that excessive money growth could be prevented under a "real bills" rule. Ricardo had made it clear long before that the only check to "overissues" in such an "inconvertible paper" world would be the "prudence" or the discretion of the bank of issue. It is very likely that this prudence could be found in Schacht's Reichsbank presidency, but the important point is that excessive monetary growth would not be curbed by some well defined quantitative limit on money creation, but by something more subjective and elusive, namely Schacht's reputation and the strength of his commitment to a "sound" monetary management. Whether this commitment could be taken for granted in October of 1923 is not merely a matter of Schacht's convictions and the strength of the government: if a settlement for the reparations issue, for instance, was not to be found monetary management, no matter how "sound", could do little to prevent the collapse of the stabilization. A second observation regarding the "limited issue" argument is related to the fact that the rentenmark was accepted by the public at a fixed rate to the dollar because it was convertible into a gold indexed bond and this fact would not be changed if no limits had been placed on its total issue . As explained in the last section the exchange rate was

He concludes then that "it was not simply the increasing quantity of central bank notes that caused the hyperinflation, since ... the note circulation continued to grow rapidly after the exchange rate and the price level had been stabilized. Rather it was the growth of fiat currency which was unbacked, or backed only by government bills, which there never was a prospect to retire through taxation". Ibid. pp. 89-90.

54 This obviously does not mean that rentenmark overissues could not happen. The supply of rentenbriefes could be so much enlarged (after all they were "paper" or "fiat" guarantees), and so could the rentenmark issue, that a point would be reached where the public would be no longer willing to accept additional quantities of the indexed bond. At this point the rentenbriefes would most likely fall to a discount, in case of which they would be underindexing the purchasing power used to buy them, so the rentenmark would stabilized as the government launched a two-pronged attack on the public's desire for "flight" from the mark by offering rentenmarks and foreign exchange at fixed rates to the old paper marks. If the rentenmark issue had been limited to some binding number, one of the "arms" of the attack would have been weakened and the responsibility for preventing the "flight" from the currency would have been placed mostly upon the limited Reichsbank reserve. Since the stock of international reserves alone was too small for the task, as it was argued against the Hilferding's stabilization proposal, it follows that there would be a minimum rentenmark issue which would make the stabilizing intervention feasible at all .

10.6) The "fundamentals" of the stabilization

The German stabilization involved, like in the other cases, an immediate problem of fixing the exchange rate, to which the rentenmark "loan" would play a major role. It would also involve, of course, a problem of solving the more fundamental "imbalances" behind the inflationary process. The true nature of these imbalances has been the matter of great controversy over the years, there being different "schools of thought" on the issue emphasizing fiscal deficits or, alternatively, balance of payments problems . Yet independently of what was the original driving force of the inflationary process it seems clear that, for stabilization purposes, most likely both issues were crucial and the solution of both should be seen as necessary ingredients of the stabilization. It was seen in Chapter 7 that the fiscal battle was won in the very act of stabilization thanks to the Oliveira-Tanzi effect. Yet, to judge from contemporary German opinion, fiscal balance was by no means a sufficient condition to assure a lasting stabilization without a major rescheduling-recycling of reparations payments . This is reinforeced by the fact that, immediately following the consequently depreciate with respect to the dollar. In this sense there would be a "critical point" beyond which additional issues of indexed bonds would characterize an "overissue" and would result in depreciating the new currency. 60 Considering a stable-prices demand for money of US$ 1,260 million and an acceptable convertibility rate of 40%, a minimum reserve of US$ 500 million would be required to establish a gold standard. Since the stock of international reserves in November of 1923 was about US$ 111 million the necessary, or the minimum rentenmark issue would be of approximately US$ 389 million or 1.633 billion rentenmark, about half of the authorized issue. 61 For revisions of this debate see C. P. Kindleberger (1984) pp. 310-311 and C. L. Holtfrerich (1986) p. 138 passim. 62 G. D. Feldman(1982) pp. 192-193, S. Schuker (1978) pp. 351-356, C. Maier (1975) pp. 286-287 passim and F. Ringer (1969) p. 92. stabilization workers managed to recover their pre-war levels of real wages, as shown in Table 10-4, despite the very high (and declining) levels of unemployment: Table 10-4 Germany: indexes of real wages and unemployment , October 1923 /June 1924 (1914=100)

date Skilled Non-skilled Unemployment 1923- October 52 52 65 19.1 November 53 53 66 23.4 December 70 70 85 28.2 1924- January 74 81 95 26.2 February 78 83 94 25.1 March 79 90 92 16.6 April 81 97 97 10.4 May 86 101 104 8.6 June 91 102 108 10.5 SOURCES: The first series for wages in each category is from ILO(1925) pp. 16-17; the second is from P. M. Garber (1982) p. 19. Unemployment figures refers to percentages of unionized workers from J. Tinbergen (1934) pp. 83-86.

In contrast to other cases, in Germany the exchange rate was fixed at a level below the market rate, thus generating a sharp one-shot appreciation of the real exchange rate. While in Poland, for instance, the option of freezing the market rate was convenient to economize their meager hard currency reserves, the Germans, on the contrary, were interested in selling the rentenmark "reserve" or in puting rentenmarks in circulation as quickly as possible. The result, however, was currency appreciation, which was actually reinforced by the relatively small inflation experienced during 1924 - around 100% for the year. This sharp deterioration in competitiveness reflected very clearly in the trade accounts. While Germany enjoyed monthly small trade surpluses of 68 million and 93 million gold marks in the last two quarters of 1923, in the first two quarters of 1924 average monthly trade deficits of 212 million and 323 million gold marks were observed . The trade deficit deteriorated further in 1924 and in 1925, as seen in Table 10-5, as the current account deficit reached nearly 5% of GDP even though reparations payments were drastically reduced, as seen in Chapter 3. It is interesting to observe that this worsening of the current account preceded the inflows of capital brought by the Dawes Plan, so that at

63 J. P. Young(1925) vol. I p. 539. least originally, these deficits were not generated by some transfer mechanism a la Machlup, but had its origins on the wage push following the stabilization. In any event the deterioration of the trade balance and the restart of the reparations payments could be more than compensated by the inflows of capital into Germany observed during the late 1920s as discussed in Chapter 3.

Table 10-5 Germany: Balance of payments, 1924-1926 (millions of gold marks)

1924 1925 1926 exportsa 7,825 9,467 10,633 imports 9,604 11,807 9,667 trade balance -1,779 -2,34 966 services 198 158 394 interest & reparationsa,b -193 -908 -1,36 current account -1,774 -3,09 -57 loans

long termc 900d 1,124 1,376 commercial creditse 500 29 -33 total capital 1,4 1,153 1,343 gold -149 -678 -578 export of foreign banknotes 1 200 - change in reserves -1,217 394 -14 unaccounted 740 2,021 -694

SOURCES and OBSERVATIONS: (a)Reparations in kind are entered as exports and as payments on reparations account. (b)Interest income was of 83 , -87 and -193 million gold marks respectively in 1924 , 1925 and 1926. (c)Net of amortization payments. (d)Securities floated abroad computed at market prices. The total par value of these issues was of 1,002 million gold marks, 960 million of which corresponded to the Dawes loan. (e)Includes net inflows of short term capital of 104 million and 118 millon gold marks respectively in 1925 and 1926. From LN (1927) pp. 81-90.

It should be clear that in the context of a dollarized economy the success of the stabilization was crucially dependent on maintaining the exchange rate fixed, which by its turn depended on having international reserves not too severely pressured. The public's acceptance of the rentenmark as hard currency worked, in the context of the model of

Chapter 5, just like an increase in international reserves, or a large external loan, to the extent that the public was willing to surrender their hard currency hoards in exchange for rentenmarks. This can be seen in the balance of payments accounts as "unaccounted inflows" and "export of foreign banknotes" - in values equivalent to US$ 414 million - both of which probably expressing dishoarding of foreign currencies that eventually found their way out of the country through the current account deficit. This meant that the current account deficit in 1924 was partly financed by private sector's "reserve losses" and also by official reserve losses of around US$ 289 million. It should be very clear that external balance thus achieved was temporary and accomplished mostly by the once and for all effect of the "sale" of rentenmarks . After this, the protection of international reserves, and consequently of the exchange rate, would have to rely on more conventional instruments and besides, it was unclear at the moment of the stabilization how long it would take for a lasting solution for the external accounts to be found. In fact, meaningful steps towards the Dawes Plan would only be announced nine months after. In this connection, the very high interest rates practiced in the few months after the stabilization, seen in Table 10-6, played an important role for the stabilization. Table 10-6 Germany: Weekly interest rates, 1923-1924 (% per year)

date daily money 14 days loans monthly loans 1923- November- 3rd week 3,23 4,238 4,74 4th week 765 3,276 3,636 December- 1st week 578 1,248 1,512 2nd week 360 641 695 3rd week 328 391 522 4th week 360 459 488 1924 - January - 1st week 81 255 300 2nd week 56 159 198 3rd week 36 75 149 4th week 15 36 36 February- 10th 12 37 31 20th 18 43 50 29th 25 42 50 March- 10th 32 43 37 20th 34 42 48 30th 29 44 49 April- 10th 35 - 44 20th 27 - 28 30th 52 - 61 May- 10th 48 - 67 20th 11 - 42 30th 12 - 28 June- 10th 12 - 35 20th 10 - 34 30th 10 - 24 July- 10th 12 - 23 20th 9 - 17 30th 11 - 17 August- 10th 10 - 15 20th 9 - 12 SOURCES: S. Flink (1930) pp. 91, 104, 122- 124 and G. Dernis(1927) p. 21.

With the sudden end of inflation the demand for money would be very significantly increased, as the velocity of circulation would be very considerably slowed. Yet the growth of money supply was slow to accommodate this "remonetization". This was due in part to the fact that the government decided to redeem the official issues of "stable valued" loans , thus reducing the amount of means of payments in circulation. Another possible vehicle for a quick increase in the money supply was the budget deficit, but this channel was actually blocked. The Treasury was only given an advance of approximately US$ 286 million in rentenmarks to finance the "temporary" budget deficits and to retire its outstanding debt with the Reichsbank. Already in December, as it is well known, the Treasury approached the Reichsbank for accommodation indicating that much of the advance had already been put into circulation. In December 31st it has been estimated that approximately US$ 250 million in rentenmarks were circulating along with US$ 147 million in gold loan notes and US$ 145 million in ordinary Reichsbank notes65. This total - US$ 542 million - even if added to private wertbestandiges and foreign currencies in circulation, was very small66 compared to the stable prices money demand. The first few weeks of the stabilization were moments of acute monetary stringency, as indeed shown in Table 10-6. The situation was alleviated in the next few months as the money supply was rapidly increased: the total authorized rentenmark issue was quickly reached in the beginning of 1924, and the stock of Reichsbank notes was increased from a total of approximately US$ 120 million in January of 1924 to US$ 220 millions in May and to US$

65 Republic of Germany (1924) p. 20 66 The gold cover ratio that had been nearly 100% in the end of November had already been reduced to 28% in December (ignoring reserve losses) 423 million in October67. The money supply would actually approach the "normal" stable prices level money demand, assumed to be around US$ 1.260 million68, only by the fall of 192469. In March of 1924, when interest rates, especially for daily money, had fallen to normal levels, some pressure was felt upon international reserves and tight was enforced from mid April. From then to the first week of August international reserves increased by US$ 158 million70, mostly by virtue of commercial credits and also by means of private dishoarding of foreign currencies. Great importance has been assigned to the April's credit crunch by some of the recent rational expectations explanations of the German stabilization. It was argued that the fundamentals of the stabilization problem were solved as the budget was quickly balanced but the credibility necessary to make the "regime change" produce the end of the hyperinflation was not a priori assured71. The final piece of the "regime change" or the element that definitively established credibility to the government's plan was the very high interest rates enforced during the first semester of 1924 and especially the credit restrictions implemented in April72. It is interesting to observe in this connection that foreign currencies remained in circulation within Germany in considerable amounts during 1924 and 1925, at least to judge from the unaccounted inflows reported in Table 10-5 for these years. Indeed, the orders of magnitude involved are fully compatible with the estimates of the amounts of foreign currencies hoarded or in circulation within Germany in 1923 reported in Table 10-2. It was only in 1925 that there was a massive return of funds, as measured by the very large unaccounted capital inflow of approximately US$ 481 million shown in Table 10-5. This seems to suggest that the

67 J.P.Young (1925) vol I p. 529 68 At least this is the base value around which the money supply seems to stabilize in the late 1920s, controlling for real growth. Cf.B.R. Mitchell (1978)p.358. 69 One might surely suggest that the monetary stringency was less a deliberate policy choice than a consequence (possibly undesired) of the fact that the increase of the money supply through the discounting of “real bills” take some time. If the government had been running a fiscal deficit the stringency could certainly have been abbreviated. This should not, however, invalidate the idea that dear money was necessary for balance payments reasons. 70 S. Flink (1930) p. 91. 71 According to Dornbusch the monetary-fiscal stabilization is, of course, a central part os the stabilization and indeed the fundamental factor. But this does not really answer the more basic question: how does a government that plans to do all the right things and, indeed, puts them on paper, secure the credibility that then makes it possible to live with the policies. Ibid, p.15 72 R. Dornbusch (1985), S. Webb (1985a) p. 19. The same point has also been made by P. M. Garber (1982) p. 27. decisive factor in securing confidence on the stabilization was not the spell of dear money enforced in the spring of 1924 but some event taking place later in 1924, most likely the approval of the Dawes plan in August and the floatation of the Dawes loan in October. It is clear from Table 10-6, on the other hand, that a premia on long (monthly) loans over short (daily) loans - an unambiguous indication of expected inflation - lasted longer than the credit crunch of April; the term structure slopes sharply upwards until the late summer of 1924 when the negotiations around the Dawes plan reached its final moments. It is very significant in this respect that the German public was very pessimistic about the state of stabilization seemingly until the Reparations Commission approved the Dawes Plan in August. There are indeed many accounts in this respect73, which provides an indication that despite all possible government demonstrations of sincerity in its commitment to "sound" finances, including actual budget balance and the credit restrictions of April 1924, the public still distrusted the program and waited for the solution for the reparations problem.

10.7) Summary and conclusions

This chapter’ purpose was to assemble the several elements that composed the German stabilization. Its emphasis was mostly directed to the workings of the “indexed currencies” mechanism that was put into effect by several private and semi-official bodies and was eventually adopted by the government through the introduction of the rentenmark. The fact that the rentenmark was a stable valued currency thanks to the “indexed money” mechanism furnishes a solution to an old and hitherto unsolved enigma namely why the rentenmark was accepted as a hard currency by the German public in November of 1923. This solution for “rentenmark miracle” played a key role in the German stabilization but other elements were also essential. The advance of dollarization was important to the extent that it meant that the fixing of the exchange rate assured that the hyperinflation would be ceased instantaneously. Regarding “fundamentals”, the solution to the fiscal imbalance provided by the operation of the Oliveira-Tanzi effect was certainly important, though seen

73 See for example C. Bresciani Turroni (1937) pp. 360-361, R. Dornbusch (1985) pp. 22-23 and H. Schacht (1927) p.152 as insufficient without a settlement of the reparations issue. In Germany one also observes a sharp improvement in real wages following the stabilization and a corresponding deterioration on the current account. Since it would take a few months for the Dawes Plan to be effectively agreed, the stabilization was sustained by the high unemployment and extreme monetary stringency, which thus made a significant contribution to bridge this crucial gap. By far, however, the most important and the most characteristic element to the German stabilization was the rentenmark miracle, a monetary innovation with no parallel in monetary history.

Epilogue

You can prove nothing by analogy. The analogy is either range-finding or fumble. Written down as a lurch towards proof, or at worst elaborated in that aim, it leads mainly to useless argument” From Erza Pound’s “ABC of Reading”

For many years high inflations have been described in very simple terms by the popular “helicopter drop” metaphor and their ends have been equally oversimplified as the building of courage to stop the printing presses. Most usually, however, historical experience tends to confirm the impression that the generation of high inflations is a much more intricate process, involving economic dislocations and “inconsistencies”, institutions and rigidities, misguided policy and personality and social conflicts and coalitions. Correspondingly, the experience of engineering of successful stabilizations does suggest that it takes the solution of a complex problem of collective decision making affected very significantly by the organization of economic interests, by institutional rigidities, by the degree of social concertation and by political circumstances. Indeed, the experience of the 1970s and the 1980s did much to reinforce these points and to debase the strength of the “helicopter drop” analogy. But it remains significant and it is nowhere stronger than in connection with the hyperinflations. For many years the hyperinflations have been epitomized the ultimate evils capitalist economies could be subject from the irresponsible management of fiduciary money. Many myths have been created and nourished by successive generations of “sound money” men. Keynes himself has even attributed to Lenin a famous remark along these lines, that is known to be untrue1. Si no e vero e bene trovato, anyhow. This work has sought to go beyond the simple interpretations, old and new, of the hyperinflations and their ends. It argued that inflation resulted curiosities later on. Science seems to start like that, with analogies, metaphors and as if explanations – and one does not need to go as far as to attribute lightning to the anger of gods – and appears to mature when the nature and the workings of the process by which diseases are produced and cured becomes the object of scientific research.

1 F. W. Fetter (1977)