Modern Economic Nonsense — The era of currency debasement
In the early 1900s, many countries struggled to pay for the Great War. Germany was no exception. By November 1918, reparations payments had pushed the country's debt to about $25 billion — nearly half its Gross Domestic Product (GDP). Faced with growing national debt and a shrinking GDP, policymakers in Germany turned to another resource abundant in their country: its central bank, the Bank Deutscher Länder (the "Banking League of Cities"). As a result, between 1910 and 1923, German monetary authorities debased their currency at an unprecedented pace. In 1912 alone, they reduced the amount of gold in their coins by 20%. Understanding why this happened helps to understand how central banks operate. A central bank is essentially a commercial bank with one primary objective: keeping inflation low. Commercial banks lend money to businesses and consumers on-demand; if they don't have enough cash on hand to make those loans, they get a loan from a lender like a securities broker or insurance company that has more cash than they need. The commercial bank expects to be paid back with interest within six months to a year — not so for a central bank lending money through its own operations. The result? A scarcity of cash for everyday transactions — and thus higher prices for goods and services — as people spend more of their money paying off existing debts instead of buying things outright.
The role of central banks in financial stability
Central banks are the primary regulator of financial institutions, managing the money supply to maintain an environment in which banks have confidence in each other's assets and liabilities. This is important because if banks don't trust each other, they don't make loans. Instead, they pull money out of the system, resulting in a credit crunch. Central banks are also responsible for monitoring and responding to systemic financial risks, and as such many central banks run financial stability operations that focus on monitoring and managing systemic risk. These include managing systemic liquidity and risk, such as monitoring for signs of financial stress in the real economy and, if appropriate, intervening in the financial system to provide liquidity.
The Causes of the German Monetary Crisis
By the end of the 19th century, Germany was the dominant economic power in Europe. Its rapid industrialization and modernization have made it one of the world's leading manufacturers and economic powers. By 1914, however, it was also the leading military power, having developed the world's first modern army. All these factors, combined with an over-ambitious foreign policy, had led Germany to become a global economic powerhouse. As a result, by 1914, it had the world's highest GDP and the largest foreign debt. Unfortunately for Germany, the war, which was fought using the latest technology, was expensive. The direct cost of the war was estimated to be $513 billion in 2017 dollars. The cost of the Great Depression, which followed the war, was estimated at $2.5 trillion in 2017 dollars. Due to its heavy debts, Germany was in a weakened state when the war ended in 1918, and it fell behind on the repayments of its debts. As a result, it was forced to begin negotiations with the other Central Powers and Allied Powers to settle its debts. By 1923, Germany's debt stood at $300 billion, and unemployment was high.
The Central Bank Response to Currency Devaluation
In response to the monetary crisis, the German Central Bank, the Bank Deutscher Länder (BDL), which controlled the country's main currency, the Reichsmark, began to debase the currency dramatically. To do this, the BDL bought billions of Reichsmarks in gold from the Federal Reserve and other central banks and then flooded the market with unlimited amounts of Reichsmarks, which caused the price of the currency to decline. In fact, the BDL printed so much money that it became nearly worthless. The BDL also began to introduce a system of interest rates that would cut the value of the Reichsmark even further, causing a vicious cycle of currency devaluation and inflation. The BDL aimed to keep the inflation rate below 10%, but as the Reichsmark constantly declined against other currencies, the money supply grew, and the inflation rate went up. This system is known as an "unstable currency regime," which was a major contributor to German inflation.
The war contributes to Currency Devaluation
The Central Bank of Germany was in a difficult position. The war had taken a toll on the country's economy. The war caused the price of goods such as food and steel to increase, which meant that the Reichsmark did not have the value it once did. Therefore, the Central Bank of Germany decided to implement a deflationary policy to bring down the price of goods to keep the value of the Reichsmark the same. It bought up foreign currencies and sold them to the public. This created a demand for foreign currencies, which devalued the Reichsmark as more and more money was printed.
The Effect of Currency Devaluation on Prices and Inflation
The BDL's policy of debasing the currency led to the hyperinflation of the 1920s and '30s. Because the Reichsmark became nearly worthless, people began to hoard it, and businesses stopped accepting it as a form of payment. People found that it was more convenient to pay for things in commodities such as bread, which had become scarce as demand skyrocketed. As the price of bread skyrocketed, people began to stockpile it, which led to widespread bread shortages. This, in turn, led to riots, looting, and violence against the government as people demanded food. The government did little to feed its citizens and was forced to shut down public services, like transportation and gas stations, as people refused to pay for them.
Why is constant devaluation bad for prices?
One of the problems with constant devaluation is that it makes it harder for businesses to obtain loans and other forms of investment financing. This negatively affects the economy and causes the prices of goods and services to rise. As more things cost more money, people find it more difficult to live, and firms find it more difficult to remain competitive. Without loans and investments, businesses find it more difficult to grow and increase their profits. Without profits, companies can't repay the government for taxes and government services, which puts them at a disadvantage as they struggle to keep up with competition from other businesses that do have the funding to invest in new technologies and products that people want to buy.
How crypto can play its role in the debasement process
Crypto can play a major role in the debasement process by allowing people to store their wealth outside of the banking system. This allows them to protect their wealth from devaluation and inflation, even if the government tries to debase its currency. By storing their wealth in a crypto wallet, people can keep their money outside of the government's control, even if it decides to go down the path of constant devaluation. It creates an alternative path to help people pay for goods and services while preventing the downward spiral of existing currency devaluation.
Concluding thoughts
The German monetary crisis of the 20th century provides a cautionary example of the dangers of constant currency debasement. In their quest to repay foreign debts and fund the Great War, German policymakers went to great lengths to weaken their currency, leading to disastrous inflation that destroyed the value of ordinary people's savings. In the end, widespread hyperinflation forced people to make it harder to survive. Perhaps, cryptocurrencies will offer an alternative route when currency debasement happens.