The Lessons from 1923 for the Euro Area: Enlightening the Dark Side of (In-) Solvent Central Banks’ Balance Sheets

Abstract

While the economic consequences of the interwar period hyperinflations are reflected in the more popular economic figures (i.e. the rates of exchange and the price indices), the lessons to learn that drove these developments are buried in overlooked figures within dusty historical archives (i.e. the financial positions from the banks of issue). In this paper we trace, by all possible means, the largely neglected effect mechanism at work during the great inflations in Austria, Hungary, Poland, and Germany by shedding light on the little noticed “dark side” (the asset side) of the respective central bank’s balance sheet. Using appropriate cointegration analyses, we show that in all four countries the central bank’s complete balance sheet – its solvency – was at the center of the action during both the period of inflation and the sudden stabilization of prices. To this aim, we develop an inflation determining (in-)solvency measure for central banks that we computed for each central bank by gathering a new data set from historical archives to cover the complete balance sheet information. Moreover, we embedded our econometric results with prevailing monetary theory and substantiated them with a variety of previously unpresented documents from real policymakers of the time that, quite literally, confirm this “central bank solvency view” on hyperinflations.

Since the revealed effect mechanism of insolvent central banks, which in the end had to be recapitalized, completely differs from the oversimplified and (mis-) leading quantity theory view on hyperinflations, we must adjust our theoretical framework to obtain effective policy recommendations in the currently restrained situation in the euro area. On the one hand, if we come to realize that the main lesson from 1923 is the imperative (re-) capitalization of the central bank, we can avert future high inflation rates in the euro area and the prospects for success, given this understanding, are actually positive. Indeed, we show that the Eurosystem is still in command of all necessary means to regain financial strength and the reforms of the four central banks in the 1920s pave the way for the system’s necessary (re-) capitalization and legal framework to secure a sound currency. On the other hand, the current debate on impending price increases turns out to be largely “overshadowed” by a mere quantitative – goods and labor market oriented – view on money and inflation, which blinds us to the truly severe inflationary risks that have built up on the asset sides of the Eurosystem’s national central banks.

In simple words, without understanding the mechanics and the threat of the Eurosystem’s insolvency, or the insolvencies of individual (Target-creditor) member banks after a breakup of the currency union, we can neither fight off or manage such a situation, nor can we prepare for the recapitalizations of our central banks that might become necessary in the near future. Historically, however, after years of suffering and countless failed policies, such recapitalizations were the only viable option for the policymakers to bring the four great inflations to an end.

Keywords: central banks, monetary policy, financial history

JEL Classification: E510, E580, N240