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Monetising deficits results in inflation

By Paul Murphy

Welcome to the most influential figure in world history you've probably never heard of: Rudolf von Havenstein.

He was president of the Reichsbank, Germany's pre-war central bank, during the First World War and then on into the disastrous years of hyper-inflation in the Weimer 1920s. While historians argue over the degree, it is pretty clear that the terrible economic collapse in Germany – along with the near-complete destruction of the country's collective wealth – associated with this period of hyper-inflation helped usher in the era of the Nazis and with them the Second World War.

And Rudolf von Havenstein was primarily to blame.

Dylan Grice, a lateral-thinking investment strategist at Société Géneralé, has been digging up some history about von Havenstein as a way of reminding us that when governments keep printing money and monetising deficits, runaway inflation is invariably the result.

As he declared in a note to SocGen clients last week:

"For all the ink spilled analysing two of the 20th century's greatest economic tragedies – the Great Depression and Japan's lost decade(s) – little has been spent on arguably the greatest of them all: Germany's hyperinflation. It may be because we're confident we understand it.

Everyone knows that unfettered money printing eventually leads to explosive inflation, don't they? The thing is, economists knew that then! So what was going through the mind of the central bank head who presided over history's most pathological currency debasement?"

He points out that at the height of the crisis, in 1923, German industrial production was collapsing at the annual rate of 37 per cent, while unemployment ballooned from under one per cent in 1922 to 30 per cent a year later. And the rest of the developed world was booming at the time.

What went wrong? Von Havenstein, by all accounts, was a likeable chap who became head of the Reichsbank in 1908. Grice fills us in: "He first seems to have developed the habit of monetising government debt during the Second World War. With a complacency arguably similar to today's policymakers in justifying their variously creative schemes for monetary and fiscal experimentation, the monetary expansion was justified as merely a stop-gap measure. The war was expected to be short and in any case the losers would be made to foot the bill.

"No one really anticipated the long and protracted conflict which occurred, or the financial burden it would impose. So by the end of the war – only 10 per cent of which was financed by taxes – the money supply had ballooned and prices had quadrupled. Nevertheless, von Havenstein was lauded as a public hero"

Once he'd got into the money printing business, however, he seems to have found it difficult to stop – and he was under quite extraordinary pressures from events and people around him.

Germany, post the first world war, was a seething, politically-dangerous place where it was impossible for the government to introduce the sort of austerity measures required to bring its deficit under control. As Grice puts it: "Facing a dilemma orders of magnitude higher but nevertheless familiar to observers of today's situation, faced with the terrifying prospect of even more economic pain should he slam on the brakes, he opted to press his foot further on the accelerator."

But there was something else. von Havenstein was handed a justification for his actions. German economists and advisors told themselves at the time that the inflationary problem was because of external factor.

Which leads Grice to his central point here: "I don't want to overplay the parallels. In fact, there is one very clear difference between the hand von Havenstein had to play then and those today's central bankers have to play now, namely the stability of today's political climate. Clearly this can change, but the class warfare, nationalistic xenophobia and revolutionary spirit poisoning the political atmosphere of 1920s Germany is at the very least dormant today, and certainly not meaningfully visible across the political landscape. But let's not ignore the parallels either: as is the case for today's central bankers, von Havenstein was faced with horrible fiscal problems; as is the case for today's central bankers, the distinction between fiscal and monetary policy had blurred; as is the case for today's central bankers, the political difficulty of deflating was daunting; and as is the case for today's QE-enthralled central bankers, apparently respectable economic theory reassured him that he was doing the right thing."

"The fact is we do understand the economics of inflation. Despite what economists everywhere say about being in 'uncharted territory' with QE, we know that if you keep monetising deficits eventually you get inflation, and we know that once you're on that path it can be extremely difficult to get off it. But we knew that then. The real problem is that inflation is a political variable and that concern over debt sustainability and unfunded welfare obligations leaves us more dependent on politicians than we have been in many decades."

The Weimer experience produced a modern central bank in Germany, and then later for the euro zone as a whole, that was utterly focused on keeping inflation under control. How then should we take this weekend's news that Germany's biggest banks – led by Deutsche Bank – are looking at a rescue plan for Greece under which they would buy Greek debt backed by financial guarantees from Berlin?

Across Europe, from Portugal to the UK, there are deficits that will only be fixed with debt eventually being paid down. If Greece is being bailed out now, what chance for central bankers having the steel to avoid monetising deficits? Once again, the major Western economies are in very dangerous waters. 

- The writer is the Associate Editor of the Financial Times


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