Financial Crises Around The World : Hyperinflation

The reasons for this catastrophe can be traced to the First World War. Germany had financed the war entirely by borrowing, rather than levying taxes. This resulted in a steady depreciation of the Mark against the US Dollar during the war from 4.2 to 8.91 Marks per dollar. The situation was further worsened by the Treaty of Versailles & the war reparations that Germany had to pay after the war. The exchange rate dropped from 32 Marks per USD in 1919 to about 90 marks per USD in the first half of 1921.

However, the "London Ultimatum” in May 1921 demanded reparations in gold or foreign currency to be paid in annual instalments as well as 26% of the value of German imports. This condition severely stymied the German economic recovery after the war. At this point, Germany neither had a fiscal surplus, nor a positive foreign trade balance. This made it quite difficult to meet the war reparation payments. Also, as reparations were required to be repaid in hard currency and not the rapidly depreciating paper Mark, one strategy Germany employed was the mass printing of bank notes to buy foreign currency which was in turn used to pay reparations.

Hyperinflation:

The inflation subsequently changed to hyperinflation. The Mark fell to 800 Marks per Dollar by December 1922, resulting in a huge rise in the costs of living, thus strangling the German middle class even more. In January 1923, French and Belgian troops occupied the Ruhr industrial region of Germany to ensure that the reparations were paid in goods, such as coal from Ruhr and other industrial zones of Germany. As the Mark became worthless, it became impossible for Germany to buy foreign exchange or gold using the paper Marks. Instead, reparations were paid in goods. Inflation was aggravated when workers went on a general strike, and the German government printed more money in order to continue paying them for passively resisting.

The situation was finally resolved with the introduction of the Reichmark & revaluation of currency. In the end, war reparations accounted for about one third of the German deficit from 1920 to 1923, & was thus the leading cause of the episode.

Analysis:

This catastrophe illustrates the crucial relations between the dynamics of printing money, and its interplay with productive capacity and free markets of a nation. In an open market economy, inflation can show itself as a sustained rise in prices or a deterioration in the balance of trade of the country. In the simple days of the gold standard, the resulting outflows of gold would readily function as a self-correcting mechanism; the central bank would have to raise rates to reverse the gold outflows and the internal demand which created the imbalance will cool off automatically.

But today, we have fiat currencies, unbacked by any commodity & driven by relationships between supply & demand, so those imbalances can persist for longer.

Lessons:

Hyperinflations are usually caused by large persistent government deficits financed primarily by money creation (rather than taxation). As such, hyperinflation is often associated with wars, socio-political upheavals, or other crises that make it difficult for the government to tax the population. But once it has started, it can be ended by implementing drastic remedies, such as imposing the shock therapy of slashing government expenditures or changing the currency basis (Zimbabwe did this by using a foreign currency, i.e., USD). Hyperinflation has always been a traumatic experience for any country & the next regime makes the central bank very aggressive about maintaining price stability (e.g. Later German policy showed far greater concern for maintaining their currency stability).