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NBER WORKING PAPER SERIES

STOPPING HYPERINFLATION:

LESSONS FROM THE GERMAN INFLATION

EXPERIENCE OF THE 1920s

Rudiger Dornbusch

Working Paper No. 1675

NATIONAL BUREAU OF ECONOMIC RESEARCH

1050 Massachusetts Avenue

Cambridge, MA 02138

August 1985

The research reported here is part of the NBER1s research programs

in International Studies and Development of the American Economy.

Any opinions expressed are those of the author and not those of the

National Bureau of Economic Research.

NBER Working Paper #1675

August 1985

Stopping Hyperinflation:

Lessons from the German Inflation

Experience of the 1920s

ABSTRACT

The special role of money in the hyperinflation process, and

particularly in the stabilization phase, has now been reconsidered in a best-

selling essay by Sargent. The message is that credible fiscal stabilization

is the sine qua non of stopping inflation. This is definitely not viewed as

being in conflict with the monetary hypothesis, but it does represent a shift

of emphasis. We draw attention to a third aspect of the hyperinflation

process, and the stablization, namely exchange rate and interest rate policy.

Even though a government may accomplish all the right measures in terms of

budget stablization or control of money creation, there remains the problem

of making these measures credible and hence being able to actually achieve

them. We argue that exchange rate and interest rate policy in the transition

have traditionally formed the vehicle for establishing that credibility by a

de facto stablization. We make that point by discussing the events of the

German hyperinflation. In that case the stablization was a much more

diffuse, accidental matter than a reading of the classics reveals with

exchange rate policy playing a key role. Immensely high interest rates in

the face of a sharply appreciating free market exchange rate wiped out

adverse speculation thus helping to establish stablization. The real

exchange rate sharply appreciated in the final stage and persisted at an

appreciated level well into the post—stabilization phase. It reflects the

reverse of the coin of real depreciation in the capital flight phase.

Rudiger Dornbusch

Department of Economics

E52—357

M.I.T.

Cambridge, MA 02139

(617) 253—3648

May 1985

STOPPING HYPERINFLATION: LESSONS FROM THE GERMAN INFLATION

EXPERIENCE OF THE 1920s

Rudiger Dornbusch

Massachusetts institute of Technology

Hyperinflations are the laboratory of monetary economics. It is

said that under these extreme rates of depreciation all other

considerations that may in normal times obscure linkages between money

and prices emerge strongly and obviously, beyond discussion or

controversy. Stabilisation of inflation proceeds If and only when the

source of inflation, money creation, is brought under control. This is

the traditional view endorsed by Keynes (1923) and particularly

developed by Cagan (1956) in his classical essay on the German

hyperinflation. The special role of money in the hyperinflation

process, and particularly in the stabilisation phase, has now been

reconsidered in a best—selling essay by Sargent (1982). In Sargent's

work primary emphasis is placed on the budget stabilisation rather

than on money growth per se. Indeed, he draws attention, as other

authors had before, to the very large rates of monetary growth

following the actual stabilisation.

Sargent's message is that credible fiscal stabilisation is the

sine qua non of stopping inflation. This is definitely not viewed as

being in conflict with the monetary hypothesis, but it does represent

a shift of emphasis. The two views are not strictly Identical because

we can imagine a budget deficit financed by domestic or external debt

finance in one case or money creation arising from creation of credit

to finance private spending. It is therefore useful to separate the

point of emphasis of the two hypotheses even though they overlap in

practice.

In this essay we draw attention to a third aspect of the

hyperinflation process, and the stabilisation, namely exchange rate

and interest rate policy. We argue that even though a government may

accomplish all the right measures in terms of budget stabilisation or

control of money creation, there remains still the problem of making

these measures credible and hence being able to actually achieve them.

Since policies are not in fact exogeneous the issue of credibility is

paramount. We argue that exchange rate and interest rate policy in the

transition have traditionally formed the vehicle for establishing that

credibility by a de facto stabilisation. We make that point by

discussing the events of the German hyperinflatlon. The discussion

also reveals that the stabilisation was a much more diffuse,

accidental matter than a reading of the classics reveals with exchange

rate policy playing a key role. Immensely high interest rates in the

face of a sharply appreciating free market exchange rate wiped out

adverse speculation thus helping to establish stabilisatlon.

The discussion also draws attention to the behavior of the real

exchange rate during stabilisation. The real exchange rate sharply

appreciated in the final stage and persisted at an appreciated level

well into the post—stabilisation phase. This may well have facilitated

the political economy of the stabilisatlon because of the implicit

rise in real wages. It reflects the reverse of the coin of real

depreciation in the capital flight phase.

initial Conditions

in the immediate aftermath of World War I Central Europe

resembled Latin America of the past twenty years: political turmoil

mixed with economic inequality, precarious democracy and financial

instability. Although the German hyperinflation stands out, problems

of high inflation or even hyperinflation prevailed In many countries,

including Russia, Austria, Poland, and Czechoslovakia. In fact, it is

doubtful that there was any country at all that escaped altogether a

significant increase in prices during World War I. The main difference

is how various countries coped with the subsequent stabilisation

effort.

It is interesting to start our analysis well before the

hyperinflation got underway and compare Germany with other major

countries. Table 1 offers a comparison focussing on the price level

and the dollar exchange rate. The benchmark is the United States and

the comparison countries are France and the U.K.

The central point emerging from Table 1 Is the large war-time

price increase everywhere, including the U.S. In the war years prices

more than doubled in the U.S. and in the U.K. In Germany and France

the increases were much larger, more than 300 percent and nearly 400.

But In this respect Germany was not much different from France.

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