The economics of inflation

May 21st, 2008

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Today, we will introduce another great book- The Economics Of Inflation- A Study Of Currency Depreciation In Post War Germany by Costantino Bresciani – Turroni, an economist who lived through the German Hyperinflation of the 1920s. That book was first published in Italian in 1931 and the English edition was first published in 1937. The foreword of this book begins:

THE depreciation of the mark of 1914-23, which is the subject of this work, is one of the outstanding episodes in the history of the twentieth century. Not only by reason of its magnitude but also by reason of its effects, it looms large on our horizon. It was the most colossal thing of its kind in history: and, next probably to the Great War itself, it must bear responsibility for many of the political and economic difficulties of our generation. It destroyed the wealth of the more solid elements in German society: and it left behind a moral and economic disequilibrium, apt breeding ground for the disasters which have followed. Hitler is the foster-child of the inflation. The financial convulsions of the Great Depression were, in part at least, the product of the distortions of the system of international borrowing and lending to which its ravages had given rise. If we are to understand correctly the present position of Europe, we must not neglect the study of the great German inflation. If we are to plan for greater stability in the future, we must learn to avoid the mistakes from which it sprang.

This book was recommended by Marc Faber and serves an excellent example of what can go wrong even in a highly cultured and advanced nation. Although history never repeats itself exactly, it rhymes and provides a grave warning to us today. If you have not already, we recommend that you read out guide, What is inflation and deflation? first before reading the rest of this article.

Now, let us turn our clocks back to Germany after the end of the First World War. For a period of time, the German economy seemed to be prospering- it was the envy of others. As Costantino wrote in Chapter 5,

It was often affirmed that only the inflation made it possible for German industry to continue to produce, there being the exceptional and interesting spectacle of extraordinary activity and prosperity in Germany at a time of general crisis in business in other countries, and especially in some of those who were victorious in the Great War.

To this view others objected that it was a question only of an “apparent prosperity,” which concealed the real and continual loss of capital, the disintegration of productive apparatus, the increasing poverty of many classes of society, and the symptoms of a crisis, which, after having remained latent for a long time, burst forth with unparalleled violence in the last months of 1923.

After the First World War, Germany had to sign the Treaty of Versailles, which required her to pay punishing war reparations. Up till 1919, the German mark fell rapidly and remained stable till the second half of 1921. As Costantino wrote in Chapter 1,

Throughout this period the movement of the mark exchange was analogous to that of the other principal European exchanges, save for a greater amplitude of fluctuation.

But from the second half of 1921 onwards (till 1923), the German mark began a downward spiral and depreciated exponentially (so much so that a diagram of the mark exchange rate with the US dollar was best drawn on a logarithmic scale). It was under this backdrop of a depreciating currency that (Chapter 5):

To that was added the influence of an economic conception, which is widely held in countries with depreciated currencies, that is the myth of “real value” or “intrinsic value.” It was thought that even if for the time being the entirely new equipment was not utilized, it nevertheless always represented an “intrinsic value,” a “substance” as it was called in Germany.

In times of inflation, the Germans hoarded capital equipment in an attempt to preserve the purchasing power of their rapidly depreciating marks. Today, we have a similar parallel- under the depreciating US dollar, prices of oil, gold, silver and commodities (including food and base metals) in general soared due in part to hoarding (see Connecting monetary inflation with speculation) and growing demand from China and India.

The initial effects of inflation in Germany seemed to be prosperity. German engineering industries were greatly stimulated during the fall of the mark. Demands for these capital goods eventually converged on the market for iron and coal, which was a great boon for these industries. There was a continuous reallocation of resources from the consumer goods industries to the capital goods industries. As Costantino quoted Professor Hirsch,

… from 1919 to 1921 an industrial migration occurred with a rapidity which had no precedent in history; more than 200,000 new workers were employed in the mines.”* The highest number was reached towards the end of December 1922.

This expansion resulted in Germany not only reconstructing their industrial capacity after the war, but also greatly enlarge them.

Sadly speaking, monetary inflation always result in distortion that are harmful to society in the long run. In Germany, the distortionary outcome was:

In the acutest phase of the inflation Germany offered the grotesque, and at the same time tragic, spectacle of a people which, rather than produce food, clothes, shoes, and milk for its own babies, was exhausting its energies in the manufacture of machines or the building of factories.

Looking back at history, we find many eerie parallels with today.

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