THE GRAND ILLUSION: THE COVERT FUNDING OF NAZI GERMANY(TM)S REARMAMENT PROGRAM, 1933 -1938

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THE GRAND ILLUSION: THE COVERT FUNDING OF NAZI GERMANY'S REARMAMENT PROGRAM, 1933 -1938

SUBMITTED TO

PROFESSOR MARC WEIDENMIER

AND

DEAN WILLIAM L. ASCHER

BY

NICOLE COLRAINE

FOR

SENIOR THESIS X190

Table of Contents

ACKNOWLEDGEMENTS 3

I. INTRODUCTION 4

II. THE GRAND ILLUSION 13

III. FINANCING THE IMPOSSIBLE 17

TABLE 1 - DISTRIBUTION OF NATIONAL INCOME 19

TABLE 2 - GERMAN ECONOMIC ACTIVITY, 1933 - 1939 21

TABLE 3- INDUSTRIAL OUTPUT OF CAPITAL AND CONSUMER GOODS 22

TABLE 4 - FLOTATION OF ARMAMENT AND WORK-CREATION BILLS BY FISCAL YEAR (MIL. RM) 25

TABLE 5 - BILL PORTFOLIOS OF GERMAN BANKS 1928-1939 (MIL. RM) 29

TABLE 6- FINANCIAL INDUSTRY: MEFO VS. NON-MEFO ANNUAL STOCK RETURNS 30

IV. THE WIZARDS OF FARBEN: 32

TABLE 7 - I.G FARBENINDUSTIE DOMESTIC SUBSIDIARIES 33

TABLE 8 - INDUSTRIAL CHEMICAL INDUSTRY: MEFO VS. NON-MEFO ANNUAL STOCK RETURNS 36

V. DOUBLE, DOUBLE TOIL 36

TABLE 9.1 - REGIONAL COAL PRODUCTION & LABOR FORCE PRODUCTIVITY AND RUHR COAL OUTPUT 37

TABLE 9.2 - LABOR FORCE PRODUCTIVITY AND RUHR COAL OUTPUT 37

TABLE 10 - COAL INDUSTRY: MEFO VS. NON-MEFO ANNUAL STOCK RETURNS 39

TABLE 11 - CAPITAL GOODS: GERMAN INDUSTRIAL PRODUCTION 1929, 1932, 1938 40

TABLE 12 -ANNUAL ELECTRIC POWER GENERATED FROM COAL, 1932 -1938 41

VII. THE MARITAL DIAMOND 41

TABLE 13 - AMERICAN AND GERMAN TUNGSTEN PRICES 44

TABLE 14 - STEEL INDUSTRY: MEFO VS. NON-MEFO ANNUAL STOCK RETURNS 46

TABLE 15 - VEREINIGTE STAHLWERKE: PROPORTION OF TOTAL GERMAN NATIONAL OUTPUT 47

VII. HIDDEN MONEY AND ECONOMIC ACTIVITY: LESSONS FROM NAZI GERMANY 48

Equation 1 - Granger Causality: General Methodology 49

TABLE 16 - CORRELATION MATRIX: VARIABLE X VS. MEFO BILL CIRCULATION (Y) 50

Equation 2 - Granger Causality Regression 52

TABLE 17 - GRANGER CAUSALITY TEST: MEFO BILL CIRCULATION AND FINANCIAL STOCK RETURNS (N=22) 52

TABLE 18 - GRANGER CAUSALITY TEST: MEFO BILL CIRCULATION AND COAL INDUSTRY STOCK RETURNS (N=22) 53

TABLE 19 - GRANGER CAUSALITY TEST: MEFO BILL CIRCULATION AND STEEL INDUSTRY STOCK RETURNS (N=22) 54

TABLE 20 - GRANGER CAUSALITY TEST: MEFO BILL CIRCULATION AND PIG IRON OUTPUT (N=22) 55

Equation 3 - Short-Run Aggregate Supply Movement 56

VII. CONCLUSION 58

REFERENCES: 62

Acknowledgements

To you, who have stood beside me, I owe more than my own life. I owe you the future. You have been strong and have not faltered even in my darkest of nights. You have held my hand tight, not allowing me to fall, you have pulled me along and together we have arrived at a better end.

I. Introduction

The First World War imparted two crucial lessons on future warmongers. Firstly, that it is crucial to have access to or possess enough raw materials needed to support all needs throughout the duration of the war. Secondly, the countries waging war should be prepared to devote all of the national income towards the war effort. From the first day that he seized control of Germany, January 30, 1933, Adolf Hitler knew that only sudden death awaited him if he failed to restore pride and empire to post Versailles Germany. In his statement to his general counsel, Adolf Hitler proclaimed that "the next five years in Germany must be devoted to the rearmament of the German people. Every publicly sponsored work creation measure must be considered from the point of view of whether it is necessary in terms of the rearmament of the German people ... For the next four to five years the guiding principal must be everything for the Wehrmacht." (Silverman, 6)

Since the end of WWII, Hitler's rearmament program has been the subject of continual controversy. Some economists and historians argue that rearmament was not the crucial factor in Germany's economic recovery while others contend that Hitler's priority to the rearmament of Germany directly resulted in Germany's remarkable economic recovery. In his article on German war preparations, economist Burton Klein attempts to demolish the myth of massive German rearmament. He asserts that Nazi economic policy was ultraconservative and shied away from rearmament because of the repercussions of inflation. (Klein, 8) Klein argues that the military effort was modest in the 1930s, and continued to be so during the first two years of war as the regime attempted to provide both guns and butter.

Historian A.J.P. Taylor emphasizes that Hitler made no serious efforts to rearm and only wanted to wage a series of small scale opportunistic wars in an effort liberate Germany from the militaristic limitations imposed by the treaty of Versailles. Klein and Taylor both conclude that with the combined problems facing the German economy in 1933 - an impoverished rural sector, a stagnant export industry, a massive balance-of-payments deficit and a credit system on the brink of collapse - the economy would have been exacerbated by high levels of military spending. Klein notes that when rearmament spending was at a record level high in 1936, it began to impose irreversible strains on the recovering German economy.

R.J Overy (1982) takes a different perspective in evaluating the key factors responsible for the German economic miracle. He asserts that the problematic situation the government undertook in 1933 was increasing both production and employment without stimulating a rise in prices. A rise in prices would have made it exceedingly difficult for the government to raise the funds necessary to prevent an unbalanced budget. He takes the stance that Germany's economic focus between 1932 - 1933 and 1934 -1935 was directed towards achieving full employment rather than developing the infrastructure for large scale rearmament because "rearmament represented some 17 percent of total government expenditure and only 1.3 percent of GNP over the period." (Overy, 65)

Kenyon Poole backs Overy's economic timeline and cites that expenditures on non-military employment projects exceeded rearmament expenses from 1932-1935. During the first stages of the Nazi regime, economic priority was accorded to restoring full employment; rearmament as a political objective surfaced later. Aimed at the elimination of unemployment, the Third Reich undertook a serious of ambitious work creation projects. Theses public works projects were a method used by the regime to stimulate industrial activity and inject life into the economy. Every unemployed German male was considered an asset to be brought into active use. Some economists believe that the contribution of public works in the restoration of the German economic revival is overstated. Harold James argues that Germany's economic recovery wasn't a house of mirror constructed by the Nazi propaganda machine. Rather, economic recovery was "real and resulted from a dramatic revival of economic activity" unaided by "statistical manipulation," a "statistical conjuring trick" or "jiggery pokery with numbers." (James, 371)

Germany's sub-standard transportation system, according to R.J Overy (1975), led to the construction of state of the art superhighways and Germany's economic recovery. A national network of highways spread throughout Germany that served to increase commerce and communication throughout the Reich. Moreover, the revitalized German highways also served to jumpstart the automobile industry and increase automobile production. On the other hand, G.F Spencley downplays the role of highway construction and believes that the revival of construction activity dominated the German economy. Timothy W. Mason supports Spencley's premise: "the economic key to recovery and to the decline in unemployment lay in the building industry, which was highly labour intensive." (Mason, 117) In his book Nazi Work Creation Programs, Dan Silverman focuses solely on Nazi public works programs and methodically argues that both the construction of the autobahn and the growth of the housing industry were the main switches activating economic recovery. Lastly, Silverman arrives at the conclusion that the Germany recovery (1933-1936) was not due to the stimulus of rearmament, which is a theory that many scholars actively defend. Rather, Silverman believes that Nazi work creation programs played the most significant role in the German economic revival.

While Overy, Spenceley, Mason and Silverman broadly agree that public works projects were fundamental in economic recovery, Avraham Barkai assumes a counter position elucidates that preparation for total war was Hitler's primary objective from day one. According to Barkai, job creation was allocated for the sole purpose of expediting rearmament. He states that Nazi polices were guided by the need for Lebensraum and economic autarky rather than the reduction of unemployment; reduction of unemployment was simply a by-product of the former. In Barkai's opinion, public works financed by deficit spending merely camouflaged the actions of rearmament. Quoting Adolf Hitler, he maintains that the first years of Nazi policy were dominated by war preparations "I can achieve just as much by rearmament as by the construction of houses and by settlement." (Baraki, 161)

Before we delve into the essence of Nazi economic policy it is important to highlight the German data limitations. One particularly important study crucial to the validity of Nazi economic data was written by Adam Tooze, who exposes the relationship between fantasy and reality in the collection and analysis of economic statistics in the Third Reich. He shows how economic censuses were designed to sustain a romantic image of the economy. Furthermore, Tooze describes the interplay between the Nazi political agenda and the professional obligations of German statisticians. He concludes that crooked financial analysis should stimulate further rethinking of the role big business played in the Nazi regime. His account of how government statistical bureaus improved their numbers during pre-war period by enlisting German big business as their ally diminishes faith is the accuracy and validity of Nazi statistical techniques.

When the Nazis assumed power in 1932, the Great Depression had destroyed the Germany economy. After it left its aftermath in the wake of the German economy, financial investors with available capital lacked confidence in the Reichsmark, they worried about Germany's ability to make reparations payments and they were especially apprehensive about the chaotic political instability within Germany. In a nutshell, Germany was a country in dire straits. As a country deficient in essential raw materials, the Reich government did not have enough foreign currency in its coffers to pay for the raw and manufactured materials needed to fuel a war economy.

The Third Reich's gold and foreign exchange reserves had virtually disappeared. (Crump, 171) In his article "Schachtian Mercantilism," N.I Momtchiloff explains that the Great Depression had transformed Germany into a nation economically crippled by debt and unemployment. Instead of the government alleviating the people's misery, they amplified the already disparaging situation due to the government's inherent instability: it was impossible for them to pursue any kind of recovery plan for more than a year or two. Germany was teetering on the edge of disaster "in just a few years there had been 224,000 suicides - a horrifying figure, bespeaking a state misery even more horrifying."(Degrelle, 300) To exacerbate this unfavorable situation, Germany's exports grinded to a halt after the Great Depression. Within a year, her trade surplus had plummeted from 2.8 billion RM in 1931 to a mere 667 million RM in 1932; about a 75 percent decline in German international trade. (Degrelle, 301) Faced with the economic obstacles of stagnate of international commerce and lack of income from foreign investments, Germany was confronted with a 'guns or butter' crisis: either Germany could buy butter, or it could buy the raw materials to make armaments, but not both. (Klein, 63)

As earlier mentioned, in order for Germany to decide between guns or butter, she needed capital to fund her expenditures. However, since the Weimar Republic was forced to make scheduled reparations payments to the victors of war, Germany's pockets were empty - she had little capital for indulgence. In his book, Hitler's Magician, Norbert Muhlen ironically proves that the Nazis in fact benefited from reparations payments "...after liberating itself from the chains of Versailles, instead of making an end of them, [the Third Reich] laid them on other nations." (Muhlen, 215) Germany sacrificed 10 billion in reparations from 1924-1931 - but Minister of Economics Hjamler Schacht worked tirelessly to wheedle and bully money from the rest of the world; within the first few years of the Nazi Regime he miraculously managed to amass18 billion RM. Foreign creditors and their governments had no idea they were financially supporting Germany's rearmament program, "so they might have guns instead of butter." (Muhlen, 214)

In considering the various forms of capital to get the economy on track, Germany's possibility of obtaining a foreign loan was out of the question; because of the depression, other countries were batting their own domestic situations and therefore could not afford to spare penny. Furthermore, foreign investors had little faith in this nearly bankrupt economy where German businesses lie motionless in their industrial graves; the one thunderous roar of production all but silenced. As far as Germany's domestic lenders were concerned, there was of course, the Reichsbank, where the option of pursuing an easy monetary policy was blocked by "the mortal fear of money expansion." (Poole, 19) With the reoccurring nightmare of hyperinflation contaminating the course of economic policy, the Reichsbank was prohibited from conducting open monetary operations (i.e. - purchasing government notes to provide the government with credit) Although macroeconomic measures were not included in the Reichsbank's toolbox of economic troubleshooting, the Reichsbank did however wield a considerable amount of control over the commercial banking sector, which gave it regulatory powers over the money and capital markets of the country. (Poole, 33) Furthermore, the Reichsbank was granted monopoly powers over foreign exchange transactions, which gave it virtual control over foreign trade. In order to gain money, the government lowered interest rates on short and long-term debt and repurchased German bonds held abroad. (Muhlen, 216)

The fundamental factor vital to Nazi economic performance was the need to increase domestic profits; in severe cases the penalty for smuggling money out of the country resulted in the death penalty. (Muhlen, 215) The Nazi's had a great deal of power over German industry and trade; industry was to be organized into government dominated estates. (Nathan, 65) These estates were created as a means to perimeter the influence of trade unions and prevent the working class from exerting any influence over German industries.

RJ Overy and Arthur Schweitzer examine the relationship between German business and the Nazi regime. Arthur Schweitzer argues that the role of big business during the Third Reich was uncertain. He argues for a "partial fascism," in which generals and big businessmen Allied with the Nazis in a failed attempt to control their own business policies. Economic and political life between 1933 and 1938 was mostly dominated by a triumvirate of political oligarchs, military figureheads, and business tycoons each dominating certain industrial sectors. All three groups joined forces for the common good; the increase German power abroad through rearmament at home. Through strong-arm tactics the Nazi party was able to get monopoly in politics. Big business as a result faced a cowed labor force and stockholders whose returns were limited by rigid legislation and economic controls; record profits were the result. R.J Overy (1982) discusses business' role in the Nazi economic recovery and concludes that "much more research is needed to arrive at a satisfactory historical judgment of the relationship between Nazism and German business."(Overy, 58)

Since Nazi economic policy was geared towards rearmament it is not surprising that the importance of Germany's industrial sectors increased exponentially. Burton Klein cites that between 1933 and 1938, the government spent approximately 90 billion RM in preparing for war -- a sum that was more than double the German national income in 1932. (Klein, 62) The expansion of the military sector would not have been possible without strict price and wage controls enforced by the government that served to suppress credit expansion. In his article The Economics of the Third Reich, Norman Crump provides a thorough account of Nazi financial policies. Nazi economic policies successfully increased economic growth via public works, rearmament orders and unemployment programs - all of which was accomplished without a massive expansion of either German currency or credit. However, in order to finance its ambitious public works projects, the Nazis had to create money that the government didn't have. Schacht and his minions in the Reich Economic Ministry "conducted a policy of deficit spending that was unprecedented in peacetime economies." (Peterson, 62) It is nevertheless true that their fear of inflation was deeply embedded in economic policy and significantly influenced the methods by which the Nazis carried out deficit spending policy.

The matter of financing the rearmament program presented a difficult problem for the Nazi regime. As previously noted, in 1934 and 1935 the German economy could by no possibility have raised funds for their extensive rearmament program through taxes and public loans. Aside from the problem of raising the huge sums required to sustain this program, Arthur Schweitzer (1982) reminds us that "the Nazi conspirators were exceedingly anxious, in the early stages, to conceal the extent of their feverish armament activities." (Schweitzer, 5) After considering various techniques of covertly financing the armament program, the Schacht developed the ingenious concept of the "Mefo" bill. One of the characteristics of Mefo that the Nazi's found especially advantageous was the fact that figures indicating the extent of rearmament that would have become public through the use of other methods could be kept secret through the use of Mefo bills; they were used exclusively for armament financing. Using Mefo as deficit financing scheme served a dual purpose: first, it diverted Reichsbank statutes, which permitted only limited financing of government expenses in the form of a loan but allowed for the inclusion of short-term commercial bills as legal coverage of the currency; second, it is thought that the Mefo strategy served to successfully camouflage the scope of rearmament.

After analyzing both sides of the aforementioned arguments and examining the corresponding data, I conclude that both rearmament activity and the role of Nazi work creation programs were vital factors that led to Germany's economic recovery. Furthermore, the covert nature of the ingenious Mefo instruments served a particularly strategic role in financing Germany's rearmament. This brings us to our present impasse: During the height of rearmament (1934-1937) many economists and historians believe that the effects of Mefo remained undetected in financial statistics and in macroeconomic indicators. However, my aim is to quantitatively measure and detect the extent to which the Mefo program remained a hidden policy before 1938.

In an effort to accurately measure this hypothesis, I used the German financial newspaper, Das Berliner Tageblatt, to collect monthly stock price over a six year period: 1933 -1938. The data set is a compilation of 126 German industrial firms from the following sectors: Iron, steel, coal, chemical, and electro-technical. These companies were not chosen at random; rather, companies were selected by separating Mefo armament firms from non-Mefo firms. I then analyzed the stock differentials between Mefo and non-Mefo firms and measured the effects of Mefo bill circulation in German money market. By examining Mefo's influence on stock returns, money supply and output production, we can objectively speculate as to what extent the Mefo rearmament scheme was a hidden policy.

II. The Grand Illusion

To wage a modern war is to fuse into a gigantic machine the resources of our most advanced technologies. Petroleum, rubber, and a host of other chemicals are the fuel of War; light and heavy materials its armor. Without aluminum, magnesium, tin, tungsten, molybdenum, quinine - those looking to wage a total war cannot survive very long. The buttress of the Allied strategy rested secure in the knowledge that they, not Germany, controlled these resources and could therefore restrict German access to them. Blockade - enforced by British dreadnaughts and backed by the US navy - had been the basic element of Allied hope to thwart the German menace. Simple in its grandeur and apparent impregnability, this barricade of the sea lanes had the semblance of a wall which a mailed fist could never breach. In 1914, the Schleiffen Plan called for a swift and overpowering march to Paris as the coup de grâce to end the war. However, since the Schleiffen Plan was not diligently obeyed, the Great War lasted longer than originally expected and resulted directly in a German defeat, a complication the axis powers did not account for. The tourniquet of the British Royal Navy constricted the German arteries of supply. By 1917, the German resource coffer that was needed to fuel its war machine was sucked dry and her people were withering away from starvation. Forced at last to surrender to the Allies, Germany studied this imprisoning cordon with great detail.
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With the cunning and aggression of Germany militancy eliminated from the world stage, the Allied forces finally relaxed. As the world order was gradually restored, science and technology forged ahead. In the early 1920's, German industry became evermore integrated and as a result, its dependence on the outer world for resources increased dramatically. However, with every addition to the myriad of materials NOT found within the Reich, it seemed to the Allied powers that the German threat was virtually eliminated. Without the necessary materials essential to technological progress, Germany was bound to her Allied captors.

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