Monetary Regimes and Inflation Monetary Regimes and Inflation History, Economic and Political Relationships Peter Bemholz Professor Emeritus ofEconomics, Centre for Economics and Business (WWZ) University ofBasIe, Switzerland Edward Elgar Cheltenham, UK • Northampton, MA, USA © Peter Bernholz 2003 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA This book has been printed on demand to keep the title in print. A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data Bernholz, Peter. Monetary regimes and inflation: history, economic and political relationshipsiby Peter Bernholz. p.cm. 1. Inflation (Finance)- History. 2. Monetary policy - History. 3. Economic stabilization. I. Title. HG229.B4852003 332.4' l-dc21 2002034659 ISBN 978 1 84376 155 6 (cased) 978 1 84542 778 8 (paperback) Contents Preface IX Acknowledgements xi 1 Introduction 1 2 Inflation and monetary regimes 3 2.1 Inflations: long-term historical evidence 3 2.2 A description of different monetary regimes 5 2.3 Monetary regimes and inflation 7 2.4 The inflationary bias ofpolitical systems 11 2.5 The influence of monetary regimes 14 2.6 Some other characteristics of monetary constitutions 15 2.7 Conclusions 18 3 Inflation under metallic monetary regimes 21 3.1 Inflation caused by an additional supply of the monetary metal 21 3.2 The debasement of metal standards by rulers 24 3.3 Reasons for the introduction and maintenance of stable metallic monetary regimes 30 3.4 Price and exchange controls 32 3.5 Consequences of inflation for the real economy 34 3.6 Conclusions 36 4 Moderate paper money inflations 40 4.1 The introduction ofpaper money 40 4.2 Paper money inflation in Sweden during the 18th century 41 4.3 Paper money inflation in Massachusetts, 1703-1749 45 4.4 Inflation during the American War of Independence 47 4.5 Paper money inflation during the American Civil War 50 4.6 Chinese paper money inflation under the Ming regime 52 4.7 Conclusions 61 5 Characteristics of hyperinflations 64 Introduction 64 5.1 Some characteristics of the French hyperinflation 66 v VI Contents 5.2 Hyperinflations are caused by government budget deficits 69 5.3 Real stock of money and currency substitution 74 5.4 Undervaluation and currency substitution 82 5.5 *Undervaluation as a consequence of currency substitution: a simple model 90 5.6 Other characteristics of hyperinflations 92 5.6.1 Consequences of high inflation for capital markets 92 5.6.2 The development ofprices 95 5.7 Economic activity and unemployment 101 5.8 The political economy of high inflation 104 5.9 Social and political consequences of hyperinflation 107 5.10 Conclusions 110 6 Currency competition, inflation, Gresham's Law and exchange rate 114 6.1 Introduction 114 6.2 Empirical evidence for periods one to three 116 6.3 *The model 118 6.4 *First period: introduction ofpaper money 121 6.5 *Second period: fixed exchange rate and loss of official reserves 122 6.6 *Third period: Gresham's Law at work 123 6.7 *Fourth Period: The return of good money 126 6.8 Conclusions 131 7 Ending mild or moderate inflations 135 7.1 Conditions favouring the stabilisation of moderate inflation 135 7.2 Restoration of stable monetary constitutions after wars at the old parity 136 7.3 Preconditions for returning to a stable monetary regime at a new parity 138 7.4 Further discussion of historical examples 146 7.5 More recent historical examples 151 7.6 Conclusions 157 8 Currency reforms ending hyperinflations 160 8.1 Introduction 160 8.2 Political-economic preconditions for initiating successful reforms 162 8.3 Sufficient economic and institutional conditions for successful currency reforms 163 Contents Vll 8.4 Characteristics of most successful currency reforms: empirical evidence 166 8.5 Less and least successful reforms 175 8.6 The influence of wrong evaluations of reform packages by the public 189 8.7 Conclusions 193 Appendix Sources for historical data not identified in the text and literature relating to different cases of hyperinflation 197 Index 207 Preface Many good books and a huge number of articles have been written on infla­ tion. As a consequence, a new book on this subject can only be justified by looking at events from a different perspective. This has been done in several respects. First, a comparative historical analysis going back to the Roman currency debasement in the fourth century and ending with the hyperinflations (that is high inflations with a monthly rate of 50 per cent or more during at least one month) ofthe 1990s has been used. Second, all 29 hyperinflations in history (which all occurred, with the exception of the hyperinflation of the French Revolution, in the 20th century) and the currency reforms ending them have been included in the analysis. Third, the political forces responsible for inflation and for ending it by adequate reforms are discussed, together with the conditions under which they can be expected to operate. Fourth, the impor­ tance of monetary regimes for the stability of money is documented. Fifth, it is shown that certain qualitative characteristics ofinflations and oftheir conse­ quences are stable traits over centuries. Finally, a clear distinction has been made between the differing traits of moderate and high inflations and the reforms necessary to end them. Chapter 1 offers a very brief historical overview. In Chapter 2 the impor­ tance of monetary regimes for monetary stability, given the inflationary bias ofpolitical systems, is documented and discussed. Chapter 3 analyses inflation ifcommodity standards in the form of metallic monetary regimes are present. In Chapter 4 moderate paper money inflations are studied, whereas in Chapter 5 all historical hyperinflations are extensively analysed. Chapter 6 provides a formal analytical framework for a complete inflationary cycle from the intro­ duction of paper money to its total substitution by stable metallic money or foreign currencies. In Chapters 7 and 8 the political and economic conditions for successfully terminating moderate and high inflations respectively are described with the help of comparative historical analyses. In writing the book formal mathematical analysis has been kept to a mini­ mum. Still, some exceptions have been made for a deeper understanding. They can however be left out by the reader without losing the general thread of the argument, and have been noted with an asterisk *. To enliven the reading of the book, short personal experiences of contemporary observers have been inserted into the text, especially in Chapter 5. They are observations by people like Ernest Hemingway and Stefan Zweig, who did not have any knowledge ix x Preface of the economics of inflation. As a consequence, the evidence provided by them is often more convincing than any econometric analysis would be. The literature on inflations is huge, so that only a part directly relevant to our argument will be quoted in the references. But to allow the reader to delve lTIOre deeply into the discussion concerning the different experiences with hyperinflation, some additional works will be mentioned in the Appendix together with the sources of the data presented. I would like to express my gratitude to Pieter Emmer, Leiden, Hans Gersbach, Heidelberg, and an anonymous referee for reading all or part ofthe manuscript and for providing important advice on how to improve it. I am also grateful to the Wissenschaftskolleg (Centre for Advanced Studies) zu Berlin, where I stayed as a Fellow for the academic year 2000/01, and was able to draw upon the generous support of the library staff when working on the manuscript. Above all, I would like to thank my wife, Elisabeth Bernholz Homann, for her patience with a husband embroiled for long months in writ­ ing this book. Acknowledgements The author and publishers wish to thank the following who have kindly given permission for the use of copyright material in Chapters 2, 4 section 6, 5 section 3, and 6. Bernholz, Peter (1983), 'Inflation and Monetary Constitutions in Historical Perspective', Kyklos, 36, 397-419. Bemholz, Peter (1989), 'Currency Competition, Inflation, Gresham's Law and Exchange Rate', Journal ofInstitutional and Theoretical Economics, 145 (3), 465-88. Bemholz, Peter (1997), 'Paper Money Inflation, Gresham's Law and Exchange Rates in Ming China', Kredit und Kapital, 30(1), 35-51. Bemholz, Peter (2001), 'Monetary Constitution, Political-Economic Regime, and Long-Term Inflation', Constitutional Political Economy, 12,3-12. Every effort has been made to trace the copyright holders but ifany have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the first opportunity. xi 1. Introduction Inflation presupposes the existence of money, which evolved as an unplanned social institution by a number ofinventions and innovations during a period of perhaps 2500 years. It was fully developed with the introduction of coins in Lydia and Ionia about 630 BC, and in China at about the same time. It follows that inflation cannot be older than money. But it seems that espe­ cially rulers soon detected the potential to increase their revenues by tamper­ ing with its value. Already in antiquity we know ofmany cases oflowering the intrinsic metallic value of coins for this purpose. Examples are the minting of bad coins by Athens during the Peloponnesian War (Aristophanes, The Frogs, 719-37) or by Rome during the Second Punic War, especially from 217 BC (Heichelheim 1955, p.