A Template for Understanding Big Debt Crises

by Ray Dalio

Germany had no option but to agree to these terms or face total occupation. It signed the treaty on June 28, 1919.

This triggered another sharp plunge in the exchange rate,28 with the mark falling 90 percent against the dollar between July, 1919 and January, 1920.

Inflation surged, hitting 140 percent by the ...

Currency declines provide a boost to exports and profit margins, as they make a country’s goods cheaper on international markets. Simultaneously, they make imports more expensive, supporting domestic industries. Devaluations also cause assets to rise in value when measured in local currency, and they attract capital from abroad as a country’s financial assets become cheaper in global currency terms.

There was also the hope that by encouraging exports and discouraging imports, the mark’s decline would be a one-off and would help bring the German balance of payments into equilibrium. According to one prominent German official:

Commenting on the choice between inflation and deflation at the time, the legendary British economist John Maynard Keynes wrote: “The inflation is unjust and deflation is inexpedient. Of the two perhaps deflation is the worse, because it is worse in an impoverished world to provoke unemployment than to disappoint the rentier [i.e., the capitalist lender].”

The stimulative policies allowed Germany to escape the global contraction and enjoy relatively strong economic conditions. Between 1919 and 1921, industrial production increased by 75 percent! However, as you can see in the charts below, levels of economic activity remained extremely depressed (e.g., industrial production and real GDP were still well below 1913 levels), and there was considerable poverty and suffering in German society. This period should be understood as one of growth within a larger period of economic contraction.

The mark’s sharp appreciation in early 1920 was an

unwelcome development for policy makers because a falling mark was considered essential to maintaining German export competitiveness, supporting employment growth, and building a savings pool of hard currency earnings. It was considered the “one good fortune in the midst of misfortune,” without which Germany would lose the possibility of exports.50 The initial appreciation hit exports hard, with the chamber of commerce going as far as to say that industry had practically “ground to a halt.”51 Unemployment surged, with the number of trade union members reported as unemployed tripling. For these reasons, the economic ministry intervened between March and June 1920—aiming to deliberately depress the mark and stimulate employment. It worked. The mark fell, competitiveness returned, and unemployment once again began to decline.

As soon as the reparation burden was announced, the mark began selling off; it declined by 75 percent by the end of the year. Inflation also returned, with prices almost doubling over the same period. For one prominent German participant at Versailles, the ultimatum fulfilled his worst fears:

Further, there was little appetite internationally to extend Germany credit on a scale that would allow it to spread out its reparation burden. This was for two reasons. First, most developed world economies were burdened by war debts of their own (primarily owed to the United States) and were also in the midst of severe recessions. Second, the German government (and most Germans) weren’t creditworthy. For instance, when the head of the Reichsbank approached the Bank of England for a 500 million gold mark short-term loan to meet the second reparation installment, he was “politely refused.”62 According to the British Chancellor of the Exchequer at the time, “the difficulty was that there was a vicious circle. Germany said she could not stop the emission of paper money and repay her obligations unless she was able to raise a foreign loan, and she could not raise a foreign loan unless she could pay her obligations.”

Of course, defaulting on the debt unilaterally was impossible, because Germany had been threatened with an invasion.

While the Reichsbank could try to defend the currency by raising rates and tightening credit, which would increase the returns on holding mark denominated assets/deposits for creditors, and thereby attract more capital from abroad while discouraging capital flight at home, it would also crush domestic demand, reduce imports, and help close the trade deficit. That would require an unimaginably severe contraction in consumption, which would have been intolerable for this already impoverished and conflict-ridden society to bear.

While policy makers knew this would contribute to inflation, they wagered that it would be the least terrible of their terrible choices.

Auto sales climbed to all-time highs, the textile trade had bookings several months in advance, cotton firms refused to take new orders, and most industries found themselves operating at full capacity and having to introduce overtime to meet the growing demand for goods.67 Once again, this burst of economic activity was not a sign of economic prosperity, but a classic flight into inflation-hedge assets. According to one Bavarian official:

The second half of 1921 also saw what one commentator called “an orgy of speculation” in the stock market.

Alarmed by the chaos in Germany, the Allied powers concluded that the German economy needed some relief from reparation payments.

J.P. Morgan, Jr. reportedly told a confidant:

Renewed optimism about meaningful relief from reparations halted the mark’s slide. By the end of January, it had risen 30 percent from its 1921 lows, and inflation, while remaining high (about 140 percent per annum), had stopped accelerating. The

In June 1922, expectations of a reparation settlement collapsed, as did the mark.

Unlike earlier, foreigners now rushed to pull their capital from Germany. As noted previously, about a third of all deposits in German banks were foreign-owned, and foreign speculation had been a huge source of support for the German economy and balance of payments. Over the next few months, about two thirds of these deposits disappeared and capital inflows collapsed.91 Simultaneously, capital flight of Germans wanting to get out accelerated; well-to-do citizens rushed to get their wealth out before the confiscatory taxes agreed to in the January compromise came into effect. The mark collapsed and hyperinflation began.

By August 1922, the economy was on the brink of financial

collapse.

The central bank was forced to respond by rapidly accelerating the pace at which it was printing marks and monetizing a...

When Keynes visited Hamburg in the summer of 1922, still in the early phase of the hyperinflation, he vividly described the phenomenon:

If it were that easy, hyperinflations would almost never occur! Instead, inflation spirals push policy makers into circumstances where printing is the least bad of several terrible options.

As you can see, currency weakness was leading inflation, which was leading money supply growth—not the other way around.

For instance, local branches of the Reichsbank found that they did not have enough actual paper notes for businesses to meet their payroll obligations.98 So, the central bank and the finance ministry allowed some large depositors to print their own currencies. These were called Notgeld—which literally means “emergency money.”

According to the Frankfurter Zeitung, by October 1922:

In January 1923, with the economy already in chaos and prompted by Germany missing a promised delivery of timber as a reparation payment, a French-Belgian force invaded Germany and occupied the Ruhr (Germany’s primary industrial region).

Miners in the Ruhr would strike in an attempt to make the occupation as costly as possible for the French government. However, this resistance would need to be subsidized by the Reich, as both the miners and their employers would have to be paid. It also meant that about half of the country’s coal supply would need to be imported, adding additional strain on the balance of payments.104 As a result, government spending increased, the balance of payments deteriorated, liquidity shortages pushed the Reichsbank to print even more, and inflation, which was already at astronomical levels, accelerated even more.

The central bank also raised rates to 18 percent (but given that inflation was running at close to 10,000 percent this was mostly a symbolic move).105 According to the president of the Reichsbank:

and hyperinflation returned stronger than before (reaching 36,000,000,000 percent by November 1923).

From July 1922 until November 1923 the mark depreciated by 99.99999997 percent versus the dollar (i.e., the cost of dollars increased 1570 billion percent) and prices rose by 387 billion percent!

By late 1923, the hyperinflation had created intolerably painful conditions within Germany.

The Allied powers concluded that without substantial reparation relief, German policy makers would remain helpless to avert a total collapse of the economy. So, in November 1923 they suspended reparations payments and reopened negotiations with the Germans on restructuring the debt.117 This gave German policy makers the breathing room they needed.

German policy makers took five crucial steps to curb inflation, each following logically from the last:

Without reparation relief, the structural drivers of the inflation would have remained intact, and it would have been highly unlikely that any new currency could have commanded faith as a store hold of wealth.

For the next 10 months, Germany did not have to make a single hard currency payment to the reparations commission.

Payments were rescheduled, and debt service costs reduced, to the point that reparations payments amounted

to only one percent of German GNP in 1924 and 1925—a reduction of over 90 percent versus 1923.125

Although Germany would still have to pay the full 130 billion gold marks of reparations, payments were now so spread out ...

As you can see, the Dawes Plan dramatically reduced the FX debt service burden.

Creating a new currency with very hard backing is the most classic path that countries suffering from inflationary deleveragings follow in order to end them.

In the Weimar case, this currency replacement process came in roughly three stages, beginning in August 1923 and ending in October 1924.126

This emergency money, though often illegal, was easier to use than the paper mark, and by the fall of 1923, nearly 2,000 types of it were actively circulating in Germany.130 Recognizing the need for a currency with a stable value, the government attempted to give a stamp of authority to this informal system.

The second phase of the transition to a new currency began on October 15, 1923, when the government announced the creation of a new national bank—the Rentenbank—and a new stable-value currency, the rentenmark, which would enter circulation on November 15.135

Specifically, the rentenmark was pegged to the paper mark at a ratio of one to one trillion, and to the dollar at a ratio of 4.2 to one—a symbolically significant exchange rate, as it set the gold value of the rentenmark equal to that of the pre-war, peace-time mark.137

The key to the new currency’s lasting success was that the Rentenbank issued relatively little of it and convincingly backed its issues with real assets.

After a year of relative stability, German policy makers implemented the third phase of the currency transition. On October 11, 1924, they introduced another new hard currency (the reichsmark), which could be purchased with rentenmarks at a one to one ratio.