Sargent argued that the end of hyperinflation in Germany was accompanied by increases in output and employment. It can be seen in Figure 1 that after the sharp decrease in output resulted from the passive contractionary policy and the French occupation of Ruhr in the inflationary year 1923, real output almost increased steadily between 1924 and 1927. Although there was lack of evidence of Phillips curve trade off between inflation and output, there were important real effects, overinvestment in many kinds of capital goods because very profligate fiscal policy will cause too much capital accumulation. This in turn led to other subsequent problems of adjustment in labour and other markets in Germany. Michael K. Salemi in 1979 and Phillip Cagan in 1991 used econometric analysis on data of Germany in 1920s respectively and concluded the same result as Sargent that the hyperinflation of Germany was not consistent with the Rational Expectation Hypothesis.
II. Austria
After World War I, Austria confronted with severe food scarcities because of the trade barriers that cut it off from the food sources due to the collapse of the Austro-Hungarian Empire. The loss of territory also led to segments of textile industry in different countries and raw materials supplies separated from industrial centers. Moreover, large-scale unemployment caused serious problems for postwar activities and the new national border. As the loser of the war, Austria also owed a huge amount of reparation. To respond to these pressures, Austria increased expenditure on food relief and unemployment insurance. However, the government did not collect enough taxes to cover expenditure and ran very substantial deficit, 50% in 1919 to 1922. The government financed these deficits by selling discounted treasury bills, thus there was rapid growth in high-powered money, which is notes and deposit of the central bank. As a result, note circulation increased 288 times from March 1919 to August 1922 and the rise in inflation was 10000% in 1921 to 1922. The exchange controls established by the government were not effective because of the ‘flight from the crown’ as the crown depreciated dramatically.
The Austrian crown stabilized abruptly in August 1922 while prices stabilized a month later. Three protocols were signed on 2 October 1922 to guide the financial reconstruction of Austria and provided conditions for an international loan of 650 million gold crowns to Austria. The new established independent central bank began operations on 1 January 1923 in order to stop large deficits and stop financing deficits by printing money. The central bank was forbidden for lending to the government except on the security of an equal amount of gold and foreign assets. Note issues of the bank were backed by minimal proportions of gold, foreign assets and commercial bills. Furthermore, the bank was obligated to resume convertibility into gold once the government’s debt reduced to 30 million gold crowns. The new currency schilling, which is equal to ten thousand paper crowns, was introduced at the end of 1924. Moreover, there was a commissioner general from the Council of the League of Nations to monitor Austria’s commitments for financial reconstruction. The Reparation Commission also modified its claim on the government resource of Austria.
Other than these monetary reforms, balanced budget was achieved by several actions within two years. Like the Germans, thousands of government employees were discharged to reduce expenditures. Prices of government-sold goods and services were raised to reduce deficits of government enterprises. New taxes were introduced and the power of government to collect taxes was much stronger.
Figure 2 shows that the stabilization of crown was accompanied by a drastic increase in the unemployment rate, although the unemployment rate already started to increase before the stabilization. The number of unemployment benefits claims increased dramatically after the termination of the hyperinflation, from 38000 in October 1922 to 117000 in January 1923. The increase in unemployment during the winters of 1924-25 and 1925-26 can be largely attributed to the earlier monetary reform. Further contributing to the increase in unemployment was the dismissal of 10000 bank employees in 1924 due to the sharp contraction of bank operations with the termination of hyperinflation.
Sargent argued that this increase was minor compared with the $220 billion GNP that would be lost in the United States per one percentage point inflation reduction. However, Wicker criticized that this obscured the seriousness of the measured employment effects. He also questioned the appropriateness of using contemporary estimates of the Phillips curve to predict the behaviour of unemployment and inflation in a newly established country after World War I whose industrial structure bore no resemblance to that of the United States. Wicker found an at least 4 percentage point increase in unemployment rate and 1% decline in real GDP which were significant to monetary reform. On all accounts, the facts of the termination of hyperinflation in Austria were difficult to reconcile with the Rational Expectation Hypothesis.
III. Hungary
Similar to Germany and Austria, as a loser of World War I Hungary owed reparations to the Reparation Commission which therefore had a lien on the resources of the government of Hungary. However, the unclear reparation obligations such as total amount owed or schedule of payments caused serious problems to stabilize the value of Hungary’s currency and other debts as there was uncertainty in the nature of the resources that backed those debts. Hungary government ran substantial deficits between 1919 and 1924. Borrowing from the State Note Institute to finance these deficits and the increasing volume of loans and discounts made to private agents led to rapid growth in high-powered money. Hungarian krone depreciated significantly while domestic prices rose dramatically.
As Austria, very similar financial reconstructions guided by two protocols were taken in Hungary to solve these problems. A reconstruction loan of 250 million gold krones in order to avoid increase domestic debts was placed abroad in July 1924. At the same time, the Hungarian National Bank took over the foreign exchange control office and assumed the assets and liabilities of the institute. Again, the bank was prohibited from additional lending to the government except full security of gold or foreign bills. Certain amount of gold reserves was also required. The Reparation Commission and several Western nations agreed to give up their liens on Hungary’s resources.
Like previous two countries, balanced budget by cutting expenditures and raising taxes was very important to end the hyperinflation. Both fiscal and monetary reforms were under the monitoring of the commissioner general. Although there was a drastic increase in central bank’s liabilities, they did not represent the ‘fiat money’ but the backed claims on British sterling, which Hungary pegged its exchange rate to.
Figure 3 shows that after the termination of hyperinflation in March 1924, the unemployment rate increased steadily until March 1925. Balancing budget deficits led to 38000, a huge reduction in the number of redundant government employees. Increased unemployment in the construction industry can be largely attributed to high real interest rates initiated by the newly established central banks as part of the monetary reform. However, the rise in unemployment in Hungary was associated with sharp reductions in the scale of bank operations resulting from the ending of hyperinflation, 4000 employees of financial institutions were discharged.
On the other hand, Sargent found that the unemployment in Hungary was not any higher than it was one or two years later thus it was consistent with the hypothesis that the stabilization process had little adverse effect on unemployment. Figure 3 also shows the unemployment fell gradually after the stabilization till December 1926. Moreover, Wicker noticed that the retail price index dropped 17% in the year following stabilization while the gold reserve increased threefold. Clearly, most evidence shows that the case of hyperinflation in Hungary supports the Rational Expectation Hypothesis.
In conclusion, there were some common features in fiscal and monetary reforms that ended hyperinflations in Germany, Austria and Hungary. The first one is the creation of independent central bank which was not allowed for additional unsecured government borrowing. The second one is simultaneous changes in the fiscal policy regime. These two features were interrelated and coordinated. The third one is the continuous rapid growth in note circulation after the stabilization, although it was the securely backed one rather than the unbacked fiat currency.
Sargent inferred from the abrupt ending of hyperinflation and the resulting magnitude of the real effect on economy such as output and employment that there was no “stubborn, self-sustaining momentum” preventing a rapid ending of inflation. He argued that abrupt ending of hyperinflation in Austria and Hungary were consistent with the Rational Expectation Hypothesis. Criticisms were given by Wicker who found adverse evidence on the case of Austria and ambiguous evidence for Hungary by analyzing unemployment data. However, It was generally agreed that hyperinflation in Germany did not support this hypothesis.
Reference
Thomas J. Sargent, Chapter 3, The end of four big inflations, Rational Expectations and Inflation, 2nd ed.
Wicker Elmus, Terminating hyperinflation in the dismembered Hapsburg Monarchy, American Economic Review, June 1986
Balderston T, War finance and inflation in Britain and Germany, 1914-1918, Economic History Review, 1989
Phillip Cagan, Expectations in the German hyperinflation reconsidered, Journal of International Money and Finance, 1991, 10, pp 552-560
Thomas J. Sargent, The demand for money during hyperinflations under rational expectations, International Economic Review, Vol. 18. 1, February 1977
Hamid Beladi, Munit A. S. Choudhary, Amar K. Parai, Rational and adaptive expectations in the present value model of hyperinflation, The Review of Economics and Statistics, Vol. 75.3, August 1993, pp 511-514
Thomas J. Sargent, Neil Wallace, Rational expectations and the dynamics of hyperinflation, International Economic Review, Vol. 14.2, June 1973, pp 328-350
Michael K. Salemi, Adaptive expectations, rational expectations and money demand in hyperinflation Germany, Journal of Monetary Economics, 5, 1979, pp 593-604
Rondo Cameron, Larry Neal, Chapter 14, International Economic Disintegration, pp 338-348, A Concise Economic History of the World: from Paleolithic Times to the Present, 4th ed, Oxford University Press
Appendix
Figure 1
Source: Converted from table in Graham (1930, p 287)
Figure 2
Source: Converted from table in League of Nations (1926, p 87)
Figure 3
Source: Converted from Table 8 in Wicker
