Playing with Inflation Matches
At some point a parent, teacher or other significant adult told you not to play with matches. You could burn down the house or school or gym. I cannot prove it, but I suspect that the number of times a child played with a match compared to the number of times a building burned down as a result would yield a very small probability. 1 chance in a 100,000? 1 in a million? The point of the cautionary tale is to help developing brains understand the potential danger contained within a matchbox despite the entertainment value.
We don’t really have the same cautionary story telling skills when it comes to economics. The consequences of actions usually unfold over years and often we only see the repeated patterns in 20/20 hindsight. In the moment, we often tell ourselves that, well, this time it’s different.
But let’s have a go by retelling a well known story about another advanced democratic economy that dealt with the consequences of a global shock…badly.
The story begins in 1921 Weimar Republic Germany. Germany lost WWI and was facing heavy reparations payments as part of the Versailles Treaty of 1919. The economic situation was grim but not necessarily dire. After all, the war had chewed up large chunks of France and Belgium. Germany’s resource and industrial base remained largely intact.
From 1921 to 1923, Germany set its printing presses on overdrive (or “brrrr” in the modern meme vernacular), launching an epic bout of hyperinflation and a new source of wall paper.
Why? The generally accepted consensus answer is that the Germans thought they could fool the markets by printing up funny money to settle their reparation debts.
But to leave it there would require an ahistoric assumption that Germany was not a sophisticated and powerful global player at the time. Germany was an economic big deal for two reasons: Coal and Steel.
Coal and Steel production were the key metrics of a modern nation in the second half of the 19th and the first half of the 20th centuries. Coal provided the base load of energy (and heating) and was a core component in the making of high quality steel. Steel in turn was the core component of factories, rolling stock, armies, navies and a vast range of consumer and industrial goods. These two industrial products were so important that as late as 1951 when six European countries united, they did so as the European Coal and Steel Community, an organization that led directly and contributed pieces to the European Union of today. Germany was a Steel and Coal powerhouse in 1921.
As part of the Versailles Treaty, Germany’s steel and coal moguls lost some of their steel mills in territories ceded to France. This was very upsetting to those powerful industrialists and therefore, it took top priority in the minds of the leaders of the fledgling Weimar Republic. To placate the industrialists, the Government decided to fire up the printing presses to compensate the industrialists even though they were well aware that the first installment of reparations was due in June 1921.
After that first installment was paid in June, the printing presses went from “fired up” to “overdrive” in August of 1921 as the German Government printed marks to acquire hard currency at any price. A dollar fetched 90 marks in the first half of 1921 (from 48 in late 1919) but brought in 320 in mid 1922 as emergency talks collapsed.
The French and the Belgians, who had just seen their countryside chewed up along with a generation of young men a few years earlier, were not in a forgiving mood. Reparations were coming up short and to add insult to injury by January 1923, the Germans had defaulted on the 34th monthly delivery (out of 36) of coal, putting French and Belgian steel mill operations in jeopardy.
When Germany skipped a shipment of lumber that was due at the beginning of 1923, Belgium and France but not Britain lost their patience along with their appetite for worthless marks. France and Belgium invaded and occupied the industrial Ruhr Valley. The goal was to grab the steel mills and coal mines. These assets would directly help rebuild war damaged industries in France and Belgium and start to pay off some of the promised reparations of the Versailles treaty in useful and powerful commodities: steel and coal.
The Ruhr valley workers and owners vigorously resisted the Occupation with much encouragement from the Weimar Government. Reichsbank printing presses went from overdrive to hyperdrive as the Government tried desperately to put cash in the hands of the patriotic striking workers and paper over the economic destruction that the Occupation of a critical industrial zone represented for the entire country at large.
The German populace rationally scrambled to buy whatever they could with the worthless marks being pumped into the economy. Inflation figures hit astronomical levels.
The inflation rate peaked in late 1923 when Germany’s Central Bank, the Reichsbank effectively had their printing presses turned off by Government edict. A brand new currency, the Rentenbank was established to issue bonds backed by a gold index and Rentenmarks were introduced into the market with 12 zeros lopped off the end. The two currencies circulated for almost a year until an August 30th 1924 law allowed holders to convert a 1 trillion mark note into 1 New Reichsmark (the 1:1 replacement for the Rentenmark). Germany “solved” the debt side of the hyperinflation ledger in a 1925 revaluation law but the savings of the working and middle classes had been wiped out and the stage was set for the end of the Weimar Republic a few years later.
So in 1921–1923 Weimar Germany, probably starting from fairly decent intentions, ended up playing with inflationary matches and burned the country down in a shockingly short time frame.
Why tell this story now? Isn’t everything just fine here in the US as we exit the COVID crisis? The “adults” in the room tell us that they are not concerned at all.
According to Federal Reserve Chairman Jeremy Powell, inflation is “not a problem.” (article) That same article claims that former Fed Chair and current Treasury Secretary Janet Yellen appears to feel the same way. Or did she backtrack a few days later? Oh no, she’s good, back on script. Hmmm.
But this story has been a few decades in the making.
Since the Greenspan put was introduced in 1987, the US Federal Reserve has effectively taken the lead in our economy and one could argue that it has “played with matches” several times in the last 35 years. We have scorched a few walls but the country’s economy is still standing.
Interestingly, the massive expansion of the monetary base has not kicked off the expected bout of inflation (especially if one ignores the harder to measure impact on asset inflation), yet.
So far, the Federal Reserve has been able to play with monetary inflation matches without getting burned.
But what about the fiscal inflation matches in our hypothetical matchbox?
The era of Big Government was pronounced “over” by the Clinton administration and members of Congress have been content to let the Fed take the lead ever since. The various administrations have jiggled the dials on military spending, discretionary spending and taxes over the past few decades but even Obamacare was not a fiscally transformative project. Most of the Federal Budget is termed Mandatory (about 70% in 2020) and goes to Social Security, Medicare and other entitlement programs. The CBO has a helpful infographic here for Fiscal Year 2020.
Whatever the labeling says, the era of Big Government has returned and the fiscal side is already well into the “stimulative” zone in 2020, taking in $3.4 trillion and spending $6.6 trillion resulting in a deficit representing 14.8% of GDP.
But all that is set to accelerate. Yup, we have decided to reach for a fistful of matches this time.
In addition to a continuation of Covid Relief, the Administration and Congress are promising to transform the country with Infrastructure, Climate Change and Racial Justice spending initiatives. Initiatives these days all carry price tags in the trillions. And these initiatives are being driven by a sense of urgency. We are responding to a specific crisis in each case. To not spend is to condemn fellow citizens to inequity, injustice and worse.
Weimar Germany tried to print and spend its way out of trouble after a catastrophic economic event. They responded to business owners and workers alike with wads of cash they couldn’t back, especially after the critically important Ruhr Valley was effectively locked down for over a year and a half. The political and financial leaders played with inflation matches and they burned the young (admittedly flawed) democracy down with hyperinflation.
Are we playing with inflation matches now?
US political and financial leaders appear to be just a little too confident that their inflation match playing is under total control. As we enter a new era where crisis driven government programs come with multi trillion dollar price tags, remember that playing with inflation matches can lead to bad outcomes. Those bad outcomes happen very quickly and the damage can be catastrophic and you can never be sure which match will be the one to start the fire.
“History does not repeat itself, but it often rhymes.” — popularly attributed to Mark Twain