Last Friday, while others observed Veteran’s Day, we remained at our desks, contemplating matters of significance for our clients—and ourselves. We took a moment to reflect on the historic Armistice and how it resonates in today’s world.
The aftermath of ‘the war to end all wars’ ushered in a chaotic new order for Europe. Economies were devastated, governments fell, and national pride was shattered. Additionally, the Treaty of Versailles compelled Germany to make reparations that its economy could not handle, ultimately leading to the catastrophic inflation of its currency. This seemed to be the only rational course of action at the time.
In various provisions of the treaty, Germany faced reparations that were impossible to meet. To alleviate this burden, the Weimar Republic resorted to printing an excessive amount of banknotes, resulting in catastrophic consequences.
Between January 1922 and November 1923, the wholesale price index skyrocketed from 36.7% to an astounding 726 billion percent. By late 1923, citizens needed 200 billion marks just to buy a loaf of bread. In essence, Germany’s currency collapsed, along with its middle class.
Interestingly, the lessons derived from Germany’s hyperinflation differ sharply from those taken by the United States during the Great Depression of the 1930s…
Lessons of the Great Depression
During the prosperous 1920s, American businesses aggressively expanded and overbuilt their capacities. Following the stock market crash at the end of 1929, it became clear that the U.S. economy’s production capacities were vastly out of sync with actual demand. This imbalance led to the collapse of the banking system’s fractional reserve debt pyramid that had sustained this excess.
At the onset of the Great Depression, former Treasury Secretary Andrew Mellon controversially advised, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Had Presidents Hoover and Roosevelt heeded this advice, the economic downturn might have been shorter, albeit abrupt. Opting instead for substantial fiscal stimulus and unproductive public work programs prolonged the depression for a decade.
On the monetary front, the Federal Reserve, which had been established in 1913, was still finding its footing and hesitated to increase the money supply. Additionally, the gold standard, requiring a 40% gold backing for Federal Reserve Notes, further constrained their ability to inject liquidity. Consequently, between 1929 and 1933, the money supply shrank by a third, leading to the collapse of the banking sector.
Nobel Prize-winning economist Milton Friedman, in his book “A Monetary History of the United States,” attributed the Great Depression primarily to the Federal Reserve’s inaction. He argued that if the Fed had taken steps to inflate the money supply, the banking system might have remained intact, preventing the loss of millions of life savings.
Today, Friedman’s perspective is widely accepted regarding U.S. monetary policy. Current Federal Reserve Chairman Ben Bernanke encapsulated this sentiment in a speech on November 21, 2002, stating, “The U.S. Government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”
Since the 2008 financial crisis, Bernanke has added $2 trillion to the Federal Reserve’s balance sheet, effectively tripling its size. Based on Friedman’s guidance from the Great Depression, this approach emphasizes inflation as a remedy for deflation.
European Money Printing: What Could Possibly Go Wrong?
In stark contrast, the lessons engraved in Germany’s collective memory revolve around the horrors of hyperinflation. Many recall tales of using money to fuel home fires, as it was cheaper than purchasing firewood. They learned from the miscalculations of Reichsbank President Rudolf Havenstein, who incorrectly believed that increasing the money supply would remedy the situation caused by the devaluation of the mark.
Currently, discussions suggest that the European Commission is attempting to gather €1 trillion for bailouts in Southern Europe and Ireland, but progress has been limited. Some estimates indicate that they may ultimately need close to €3 trillion.
In short, the funds required for these bailouts are nonexistent, and the banking sector finds itself insolvent. At the same time, rising interest rates in credit markets are impeding these countries’ ability to manage their substantial debts. The alternatives seem limited, with the European Central Bank’s printing press emerging as a potential solution.
Given the challenges faced by Europe, the temptation to resort to money printing is gaining momentum across the continent. While ECB buys of sovereign debt have thus far been balanced by sales of new euro paper, that may change soon. The aim of monetary inflation would be to print euros in substantial quantities to devalue the currency and ease the debt burden on these over-leveraged nations. Following the U.S. model led by Bernanke, the ECB may find itself leaning toward this expedient solution, despite Germany’s historical caution.
What, indeed, could possibly go wrong?
Sincerely,
MN Gordon
for Economic Prism
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