The German hyperinflation episode in the early 1920s is often quoted as an example of the dire consequences of excessive money printing – a leading industrial economy succumbing to the dangers of currency debasement promoted by incompetent central bankers.

Alas, the reality is more complex than that, particularly when certain geopolitical and economic constraints of that time are taken into consideration. And as we shall see, we can draw some important lessons from that episode that can help us gauge the effectiveness of our very own currency debasement in the 21st century.

Setting the Stage

Europe radically changed in the aftermath of World War I. Gone were the big empires of Central Europe, and the fragmented states that emerged from them had to cope with a much more modest and uncertain modus operandi. There was a new power emerging farther out in the East, after the Bolsheviks took over Russia, boldly proclaiming that they would not stop there. On the other side of the Atlantic, America demonstrated that it could muster the necessary resources to prevail in a major world conflagration, and that it could become a power to be reckoned with.

Great Britain retained its dominant superpower status, no longer challenged by the once mighty German forces. Because it had security, its major concern henceforth was economic, especially as a countermeasure to the rising Bolshevik threat. France, on the other hand, remained exposed to a resurgent Germany, particularly because the latter had come out of the war with its industrial capability largely intact. Consequently, its concerns were mainly political.

The French believed that the peace of Eastern Europe was a primary concern of the states of Western Europe and that Germany should never be allowed to reassert itself eastwards; the British saw the two sides of Europe as separated, particularly because the eternal squabbles of Eastern Europeans could drag yet again the major Western powers into another regional conflict, very much like 1914. France believed that Germany could only be made to keep the peace by duress; Britain believed that Germany could be persuaded to keep the peace by concessions.

While it was not known then, these divergent views would eventually set the stage for Germany’s hyperinflation episode.

German Reparations

War reparations became a major factor of contention between Western European countries. The French in particular were quite unhappy with results of the Treaty of Versailles, and sought redress at every opportunity.

The preliminary payments were supposed to amount to a total of 20 billion marks by May 1921, but the recipients contended that only about 8 billion of this had been paid. As a result, Germany received a number of demands and ultimatums from the victors, including the threat of occupation of the Ruhr earlier that year.

Under significant pressure, the Germans eventually agreed to issue bonds totaling 132 billion marks as the total reparation bill. Of these, 82 billion were set aside and forgotten. The remaining 50 billion would be paid in annual installments of 2 billion marks plus a share of German exports.

However, Germany would only be required to pay these obligations if two conditions prevailed: first, that it had a fiscal surplus, so that the government had additional resources beyond what was required to meet its current obligations; second, that it had a positive foreign trade balance, enabling the country to accumulate enough gold or foreign currencies to settle the reparations.

As it turned out, neither of these conditions existed throughout the entire 1920s, and as such Germany was never in a position to pay any reparations. Money printing ended being the result, although the real drivers of that policy did not lay in the reparations alone.

Inflation Breaks Out

Far from it in fact. The failure to obtain a fiscal surplus was solely the responsibility of the German government, which refused to reduce its own expenditures and the standards of living of its people, or to tax them enough to yield such a surplus.

Germany’s creditors shared the blame for its failure to obtain a favorable balance of trade. While the Germans made little or no effort to reduce their purchases abroad, which would have also curtailed their standard of living, they adamantly refused to allow a free flow of German goods into their countries on the premise that this would undermine their own industries.

Once again, the interpretation of these failures was colored by the geopolitical inclination of the creditor in question. The British saw them as evidence of Germany’s inability to pay, while the French believed that they simply did not want to pay. Actually, both were correct.

Had Germany been allowed to export freely, it probably could have produced enough goods and services to service a meaningful portion of the reparations, as indicated by its comparatively higher per capita income levels as the decade progressed. With this option not on the table, the German government ran successive budget deficits, instead of implementing painful tax increases and budget cuts (“austerity” in today’s lingo). The funding vehicle: central bank lending (the equivalent of our “quantitative easing”).

Therefore, it was not necessarily the reparations per se that sparked a significant rise in the inflation rate, but rather the policies of the German government intended to circumvent them. The restriction to the free flow of German goods to creditors’ markets substantially compounded the problem – a point which is often underappreciated in understanding the reasons behind the acceleration of inflation during that initial phase.

And accelerated it did. While the par value of the German mark to the British pound was at around 20, it fell from 305 in August 1921 and then to 1,020 by November that year.

But the worst was yet to come.

Germany Loses the Ruhr

The effects of inflation were felt very unequally across German society. Those whose property was in real wealth, either in land or industrial plants, gained from the inflation as it increased the value of their properties and wiped away their debts. It was the middle class (as always) that was getting ruined.

In July 1922, Germany demanded a moratorium on all cash payments of reparations for the next thirty months. Although the British were willing to yield at least to part of this, the French argued that the Germans had made no real effort to pay their debts and that, accordingly, such moratorium would only be acceptable to them if accompanied by adequate guarantees.

This meant that the creditors should take possession of various forests, mines and factories of western Germany, as well as the German customs, to obtain incomes which could be applied to reparations. As such, in January 1923, the Reparations Commission voted 3 to 1 (with Britain opposing France, Belgium, and Italy) that Germany was in default of its payments. Armed forces of the three nations began to occupy the Ruhr two days later.

This area was vitally important for the German economy. With 10% of the population, it produced 80% of the country’s coal, iron and steel and generated 70% of its freight traffic. As a result, Germany retaliated, declaring a general strike in the area, ceasing all reparations payments and adopting a program of passive resistance. As a result, more paper money had to be printed to support the strikers.

By the end of 1923, the output of the area was brought down to one-third its capacity. At this point the German mark had all but collapsed, going from 80,000 marks to the pound in January 1923 to 20 billion by December 1923.

And here’s another important point to bear in mind: it was the curtailment of Germany’s productive capacity, sustained with even more money printing, which sealed the demise of its currency.

Resolution

Resistance in the Ruhr put a great strain on Germany, both economically and financially, and a great psychological strain on the French and Belgians. At the same time that the German mark was being ruined, the occupying countries were not obtaining the reparations they desired.

Accordingly, a compromise was reached by which Germany accepted another plan for reparations (the Dawes Plan) and the Ruhr was evacuated.

The victors in this episode were the British, who had demonstrated that the French could not use force successfully without British approval. This would have important geopolitical consequences in the years that followed.

But there were other victors as well: the radical political parties in Germany, feeding on the resulting humiliation and frustration felt by large parts of the population. The most radical of them would rise to power within a decade.

Lessons for Today

This episode illustrates less obvious yet crucially important points on the dynamics of money printing, particularly when interplayed with productive capacity and free markets. Abundant paper credit might be a necessary condition to generate high inflation rates, but in today’s world it is far from being a sufficient condition.

In an open economy, inflation can manifest itself as a sustained increase in prices and/or a deterioration in the balance of trade. Regarding the latter, in the days of the gold standard, the resulting outflows of gold would function as a self-correcting mechanism: the central bank would have to raise rates to reverse those outflows and cool off the internal demand which created the imbalance in the first place.

Today we have fiat currencies, driven by differentials in interest rates, inflation expectations, risk premiums, credit creation and so forth, so those imbalances can persist for longer. And there’s one vital improvement relative to the 1920s (in fact all the way up to the late 1970s): virtually limitless production capacity.

Over the past few decades capitalism and globalization made possible the rapid assembly of production capacity anywhere in the world – by entrepreneurs and, in some very important cases, central planners (read: China). Supply can thus rapidly rise to absorb increases in demand, dampening any lasting effects on price.

Global markets have become very efficient in spotting price arbitrage opportunities and eliminating them through the free movement of capital and goods. The result: an inherently deflationary system for Western economies, particularly when coupled with high debt loads that can curtail the sustainability of pickups in demand.

Don’t believe us? Just look at the evolution of China’s foreign exchange reserves during the last quantitative easing program by the US Federal Reserve.

Monthly Foreign Exchange Reserves in China (USD bn (LHS), yoy% (RHS)):

Sep 12-Dec 14

Source: PBOC, J Capital.

Those newly minted US dollars went to China in search of yield and cheaper goods and services, as evidenced by the rise and fall of the latter’s growth in foreign exchange reserves almost in sync with the Fed’s money printing. Any wonder why inflation remains subdued in the US?

As long as global markets remain open and free, Western policymakers will have a hard time creating lasting inflation. Of course there is a number that might do it. But some developments could make this a near certainty, as we have seen from Germany’s episode: a big deflationary shock could bankrupt and take out large portions of industrial capacity; water constraints and evolving weather patterns could limit food production; energy might become much more expensive at some point; capitalism can be dismantled; free trade could be severely restricted (more Russian sanctions anyone?).

And if we get there under these circumstances, our central bankers may discover that they have as many unpalatable choices as their German peers in the early 1920s.