Capital flight is a traditional response to currency collapse. Those who could convert marks into Swiss francs, gold or other stores of value did so and moved their savings abroad. Even the German bourgeoisie was not immediately alarmed as losses in the value of their currency were offset by stock market gains. The fact that these gains were denominated in soon to be worthless marks had not yet occurred to many. Finally, those who held unionized and government jobs were initially hedged as well because the government simply granted wage increases commensurate with inflation.
Of course, not everyone had a government or union job, stock portfolio, hard assets or foreign operations to insulate them. Those most devastated were middle-class pensioners who no longer qualified for raises and savers who kept their funds in banks rather than stocks. These Germans were completely financially ruined. Many were forced to sell their furniture to raise a few marks to pay for food and keep going. Pianos were particularly in demand and became a form of currency on their own. Some elderly couples whose savings had been destroyed would go into the kitchen, hold hands, place their heads in the oven and turn on the gas in a poignant form of suicide. Property crime became rampant and, in the later stages, riots and looting were common.
In 1922, the inflation turned to hyperinflation as the Reichsbank gave up trying to control the situation and printed money frantically to meet the demands of union and government workers. A single U.S. dollar became so valuable thatAmerican visitors could not spend it because merchants could not locate the millions of marks needed to make change. Diners offered to pay for meals in advance because the price would be vastly higher by the time they finished eating. The demand for banknotes was so great that the Reichsbank engaged numerous private printing firms and used special logistics teams in order to obtain enough paper and ink to keep the printing presses rolling. By 1923, the notes were being printed on one side only to conserve ink.
With economic chaos reigning, France and Belgium invaded the German industrial region of the Ruhr Valley in 1923 in order to secure their interests in reparations. The invasion enabled the occupiers to obtain payment in kind through shipments of manufactured goods and coal. The German workers in the Ruhr responded with work slowdowns, strikes and sabotage. The Reichsbank rewarded the workers and encouraged their resistance by printing more money for higher wages and unemployment benefits.
Germany finally attempted to halt the hyperinflation in November 1923 by creating an alternate currency, the rentenmark, which initially circulated side by side with the paper mark. The rentenmark was backed by mortgages and by the ability to tax the underlying properties. Their issuance and circulation were carefully managed by the newly appointed currency commissioner, Hjalmar Schacht, a seasoned private banker who would soon replace von Havenstein as head of the Reichsbank. When the final collapse of the mark came shortly after the rentenmark was introduced, one rentenmark was roughly equal to one trillion marks. The rentenmark was a temporary fix and was soon replaced by a new reichsmark backed directly by gold. By 1924, the old hyperinflated paper marks were literally being swept away into dustbins, drains and sewers.
Economic historians customarily treat the 1921–1924 hyperinflation of the Weimar Republic separately from the worldwide beggar-thy-neighbor competitive devaluations of 1931–1936, but this ignores the continuity of competitive devaluations in the interwar period. The Weimar hyperinflation actually achieved a number of important political goals, a fact that had repercussions throughout the 1920s and 1930s. Hyperinflation unified the German people in opposition to “foreign speculators” and it forced France to show its hand in the Ruhr Valley, thus creating a case for German rearmament. Hyperinflation also evoked some sympathy from England and the United States for alleviation of the harshest demands for reparations emanating from the Versailles Treaty. While the collapse of the mark was not directly linked to the value of reparations payments, Germany could at least argue that its economy had collapsed because of hyperinflation, justifying some form of reparations relief. The currency collapse also strengthened the hand of German industrialists who controlled hard assets in contrast to those relying solely on financial assets. These industrialists emerged from the hyperinflation more powerful than before because of their ability to hoard hard currency abroad and buy up assets of failed enterprises on the cheap at home.
Finally, the hyperinflation showed that countries could, in effect, play with fire when it came to paper currencies, knowing that a simple resort to the gold standard or some other tangible asset such as land could restore order when conditions seemed opportune—exactly what Germany did. This is not to argue that German hyperinflation in 1922 was a carefully thought-out plan, only that hyperinflation can be used as a policy lever. Hyperinflation produces fairly predictable sets of winners and losers and prompts certain behaviors and therefore can be used politically to rearrange social and economic relations among debtors, creditors, labor and capital, while gold is kept available to clean up the wreckage if necessary.
Of course, the costs of hyperinflation were enormous. Trust in German government institutions evaporated and lives were literally destroyed. Yet the episode showed that a major country with natural resources, labor, hard assets and gold available to preserve wealth could emerge from hyperinflation relatively intact. From 1924 to 1929, immediately after the hyperinflation, German industrial production expanded at a faster rate than any other major economy, including the United States. Previously countries had gone off the gold standard in times of war, a notable example being England’s suspension of gold convertibility during and immediately after the Napoleonic Wars. Now Germany had broken the link to gold in a time of peace, albeit the hard peace of the Versailles Treaty. The Reichsbank had demonstrated that in a modern economy a paper currency, unlinked to gold, could be debased in pursuit of purely political goals and those goals could be achieved. This lesson was not lost on other major industrial nations.
At exactly the same time the Weimar hyperinflation was spiraling out of control, major industrial nations sent representatives to the Genoa Conference in Italy in the spring of 1922 to consider a return to the gold standard for the first time since before World War I. Prior to 1914, most major economies had a true gold standard in which paper notes existed in a fixed relationship to gold, so both paper and gold coins circulated side by side with one freely convertible into the other. However, these gold standards were mostly swept aside with the coming of World War I as the need to print currency to finance war expenditures became paramount. Now, in 1922, with the Versailles Treaty completed and war reparations established, although on an unsound footing, the world looked again to the anchor of a gold standard.
Yet important changes had taken place since the heyday of the classical gold standard. The United States had created a new central bank in 1913, the Federal Reserve System, with unprecedented powers to regulate interest rates and the supply of money. The interaction of gold stocks and Fed money was still an object of experimentation in the 1920s. Countries had also grown used to the convenience of issuing paper money as needed during the war years of 1914–1918, while citizens had likewise become accustomed to accepting paper money after gold coins had been withdrawn from circulation. The major powers came to the Genoa Conference with a view to reintroducing gold on a more flexible basis, more tightly controlled by the central banks themselves.
From the Genoa Conference there emerged the new gold exchange standard, which differed from the former classical gold standard in significant ways. Participating countries agreed that central bank reserves could be held not only in gold but in the currencies of other nations; the word “exchange” in “gold exchange standard” simply meant that certain foreign exchange balances would be treated like gold for reserve purposes. This outsourced the burden of the gold standard to those countries with large gold holdings such as the United States. The United States would be responsible for upholding the gold value of the dollar at the $20.67 per ounce ratio while other nations could hold dollars as a gold proxy. Under this new standard, international accounts would still be settled in gold, but a country might accumulate large balances of foreign exchange before redeeming those balances for bullion.
In addition, gold coins and bullion no longer circulated as freely as before the war. Countries still offered to exchange paper notes for gold, but typically only in large minimum quantities, such as four-hundred-ounce bars, valued at the time at $8,268 each, equivalent today to over $110,000. This meant that gold bullion would be used only by central banks, commercial banks and the wealthy, while others would use paper notes backed by the promises of governments to maintain their gold equivalent value. Paper money would still be “as good as gold,” but the gold itself would disappear into central bank vaults. England codified these arrangements in the Gold Standard Act of 1925, intended to facilitate the new gold exchange standard.
Notwithstanding the return to a modified gold standard, the currency wars continued and gained momentum. In 1923, the French franc collapsed, although not nearly as badly as the mark had a few years earlier. This collapse memorably paved the way for a golden age of U.S. expatriates living in Paris in the mid-1920s, including Scott and Zelda Fitzgerald and Ernest Hemingway, who reported on the day-to-day effects of the collapse of the French franc for the
Toronto Star
. Americans could afford a comfortable lifestyle in Paris by converting dollars from home into newly devalued francs.
Serious flaws in the gold exchange standard began to emerge almost as soon as it was adopted. The most obvious was the instability that resulted from large accumulations of foreign exchange by surplus countries, followed by unexpected demands for gold from the deficit countries. In addition, Germany, potentially the largest economy in Europe, lacked sufficient gold to support a money supply large enough to facilitate the international trade that it needed to return its economy to growth. There was an effort to remedy this deficiency in 1924 in the form of the Dawes Plan, named after the American banker and later U.S. vice president Charles Dawes, who was the plan’s principal architect. The Dawes Plan was advocated by an international monetary committee convened to deal with the lingering problems of reparations under the Versailles Treaty. The Dawes Plan partially reduced the German reparations payments and provided new loans to Germany so that it could obtain the gold and hard currency reserves needed to support its economy. The combination of the Genoa Conference of 1922, the new and stable rentenmark of 1923 and the Dawes Plan of 1924 finally stabilized German finance and allowed its industrial and agricultural bases to expand in a noninflationary way.
The system of fixed exchange rates in place from 1925 to 1931 meant that, for the time being, currency wars would play out using the gold account and interest rates rather than exchange rates. The smooth functioning of the gold exchange standard in this period depended on the so-called “rules of the game.” These expected nations experiencing large gold inflows to ease monetary conditions, accomplished in part by lowering interest rates, to allow their economies to expand, while those experiencing gold outflows would tighten monetary conditions and raise interest rates, resulting in an economic contraction. Eventually the contracting economy would find that prices and wages were low enough to cause its goods to be cheaper and more competitive internationally, while the expanding economy would experience the opposite. At this point the flows would reverse, with the former gold outflow country attracting inflows as it ran a trade surplus based on cheaper goods, while the expanding economy would begin to run a trade deficit and experience gold outflows.
The gold exchange standard was a self-equilibrating system with one critical weakness. In a pure gold standard, the gold supply was the monetary base and did the work of causing economic expansion and contraction, whereas, under the gold exchange standard, currency reserves also played a role. This meant that central banks were able to make interest rate and other monetary policy decisions involving currency reserves as part of the adjustment process. It was in these policy-driven adjustments, rather than the operation of gold itself, that the system eventually began to break down.
One of the peculiarities of paper money is that it is simultaneously an asset of the party holding it and a liability of the bank issuing it. Gold, on the other hand, is typically only an asset, except in cases—uncommon in the 1920s—where it is loaned from one bank to another. Adjustment transactions in gold are therefore usually a zero-sum game. If gold moves from England to France, the money supply of England decreases and the money supply of France increases by the amount of the gold.
The system could function reasonably well as long as France was willing to accept sterling in trade and redeposit the sterling in English banks to help maintain the sterling money supply. However, if the Banque de France suddenly withdrew these deposits and demanded gold from the Bank of England, the English money supply would contract sharply. Instead of smooth, gradual adjustments as typically occurred under the classical gold standard, the new system was vulnerable to sharp, destabilizing swings that could quickly turn to panic.
A country running deficits under the gold exchange standard could find itself like a tenant whose landlord does not collect rent payments for a year and then suddenly demands immediate payment of twelve months’ back rent. Some tenants would have saved for the inevitable rainy day, but many others would not be able to resist the easy credit and would find themselves short of funds and facing eviction. Countries could be similarly embarrassed if they were short of gold when a trading partner came to redeem its foreign exchange. The gold exchange standard was intended to combine the best features of the gold and paper systems, but actually combined some of the worst, especially the built-in instability resulting from unexpected redemptions for gold.