Monetary reforms in comparison - Denmark (1813) and Germany (1948)

Table of contents

1. Introduction

2. About the necessity of monetary reforms
2.1. Advanced open inflation
2.2. Great suppressed inflation
2.3. The reform bundle for advanced open inflation
2.4. The reform bundle for great suppressed inflation

3. The monetary reform in Denmark (1813)
3.1. Pre-reform state
3.2. Reform’s enforcement

4. The monetary reform in Germany (1948)
4.1. Pre-reform state
4.2. Reform’s enforcement

5. Similarities and differences
5.1. Two reforms in overview
5.2. Money stock estimation

6. Conclusion

Symbol directory

Bibliography

1. Introduction

The history of money is also a history of monetary reforms. In every episode of history there were times of very high inflation which made sanitation of the monetary system necessary. Often wars were the trigger for inflation: Wars normally cause large expenditures for army and weapons which the governments have to finance. These large amounts of money usually can not be covered by the regular budgets over the duration of the war. So the warring governments are forced to open new sources of capital which means foremost rising taxes and duties. Because tax revenues usually decline in war times, the improvement of tax income can not be sufficient. In the next step the government starts printing money or expands the money stock through new debts from the central bank. The printing of money has become easier since the abolishment of gold and silver coins, the introduction of bank notes, and finally virtual money. This is why we can observe an increasing number of monetary reforms in the 20th century^[1].

In most cases the broadening of money supply leads to increasing prices. The rate of inflation exceeds the ordinary magnitude and causes several economic problems. I will talk about these effects in general in the next chapter. If the attempts of the government to restore a functioning monetary system fail, the ultima ratio is a monetary reform in order to establish a new system.

In the history of a certain country a monetary reform is relatively unique. In Denmark for example two monetary reforms took place, namely in 1813 and 1945. In Germany we can find three reforms all together in the last century (1924, 1948 and 1990^[2] ). In this paper I will take a deeper look into the monetary reforms in Denmark in 1813 and in Germany in 1948, the trigger points that lead to their necessity and their success.

By comparing these two as representatives out of the several monetary reforms that were implemented in world history, I will try to derive a general recommendation for decision-makers of a prospective monetary reform. But first of all I will analyse the reasons why monetary reforms can become inescapable from a theoretical point of view.

2. About the necessity of monetary reforms

When talking about monetary reforms, I will follow Bähr (1994) and use her concept of monetary reforms for governmental decisions which include more than bare monetary measures. A monetary reform at least consists of:

- The introduction of a new currency unit,
- Changes in the legal constitution of the central bank,
- Changes in the principles of exchange rate and convertibility.^[3]

This concept postulates the importance of the different parts of a reform bundle. The re-establishment of a monetary system is a necessary part of this bundle however it is not sufficient to gain success. Therefore political and institutional changes also have to be carried out.^[4] In consequence smaller, partial reforms like the monetary unification 1871 in Germany are not covered by this definition.^[5]

The main target of monetary reforms is the elimination of either great suppressed or advanced open inflation within the economy. Both types of inflation have different characteristics which have to be taken into account.

2.1. Advanced open inflation

The literature divides different open inflation states in creeping, trotting, galloping and hyperinflation. However, there are no general percentage rates for an accurate differentiation between theses states. The open inflation in an advanced state, which will be subject matter in this paper has the attributes of high increases in price level and decreases in real money stock.^[6]

In cases of long term high inflation rates the persistently changing prices lead to increasing inefficiencies within the economy. The money in circulation can not fulfill its functions (store of value, unit of account and medium of exchange) within the monetary system any further.^[7]

The economic subjects anticipate price increases by reducing the duration of contracts and their money storage. They try to change the money they earn as fast as possible into tangible assets or barter goods to avoid losses of value in inflationary money. The money is sometimes substituted by foreign money or bartering goods like cigarettes. The velocity of money increases significantly. Altogether this leads to a decreasing demand for money, and therefore to a reduction in real money stock below the pre-inflationary level.^[8] These inefficiencies cause large costs for transactions and harm the whole economy. Solely the state benefits partly through the real debt reduction through the inflation tax. Seldom this gain is sufficient to balance the budget. On the contrary the government has to use more money printing because the real value of tax revenues decreases.^[9] In most cases of open inflations the origin is this monetary alimentation of governmental budget deficits.^[10]

The necessity of a monetary reform in cases of advanced open inflations as described above results out of three main aspects:

- Increasing negative effects on the economy,
- Intrinsic dynamic of the inflationary process through anticipation and changes in behavior,
- Impossibility of stabilization either with restrictive fiscal and monetary policy or means of income control (price and wage freeze).

A monetary reform as ultima ratio aims on ending inflation und re-establishing a trustful monetary system that fulfills the money functions. The liquidity has to be sufficient but low enough to prevent further inflationary tendencies. To support the reform with plausibility the government has to put an end on budget deficits and the central bank has to gain independence. Finally, the exchange rate has to be stabilized.^[11]

2.2. Great suppressed inflation

In contrast to the advanced open inflation, where we observe constantly increasing prices, the potential inflation is suppressed by administrative means in this inflation type. The prices are fixed to prevent price increases caused by demand surpluses. Surpluses arise because the money stock grows much faster than the output production. The consumers can not consume their money and the money keeping increases. The producers on the other side are fully employed, the delivery time increases and the inventories deplete. Indicator for the degree of inflation is the coefficient of cash which increases with rising supply gap. Unfortunately, the cash coefficient and other evidence for suppressed inflation like forced saving, waiting queues and rising black market prices are not exact enough to measure the inflation state correctly.^[12]

At the beginning the maximum prices must not be supported with control measures like rationing and quota allocation. Over time the supply gap increases and even substitution with lower quality goods is not possible any more. Then the government enforces further price controls and rations also the substitution goods. Coupon systems have to overtake the allocation of goods from the price mechanism. This state is defined as great suppressed inflation and occurred in times of war conditioned central planning as in the 1940s or as durable phenomenon in socialistic centrally planned economies.^[13]

A monetary reform in this state of great suppressed inflation is inescapable because of two aspects:

- Negative effects for the economy,
- Impossibility of stabilization with conventional anti-inflation policy.

The suppressed inflation is not as obvious as the open inflation and the individuals are unclear about the real value of their money. The distortion of price relations and its effects on allocation and employment make the suppressed inflation much more dangerous for the economic development than the open inflation.^[14]

Typical characteristics of inflation

Advanced open inflation Great suppressed inflation

(1) Erosion of the monetary system (1) Erosion of the monetary system

(1a) Decreasing real money stock (1a) Existence of money surplus

(1b) Increasing impairment of money functions (1b) Increasing impairment of money functions

(1c) Growing substitution of inflationary money (1c) Growing substitution of inflationary money

(1d) Substantial increases in velocity of money (1d) Decreasing velocity of money

(2) Nominal money stock growth (2) Nominal money stock growth

and budget deficits and budget deficits

(2a) High budget deficits covered increasingly

by money printing

(2b) Increasing deficits owing to the

influence of inflation

(3) Undervaluation of domestic currency (3) Foreign exchange control

(4) Maximum prices and central planning

(4) Loss of confidence in the (5) Loss of confidence in the

domestic currency domestic currency

Table 1: The typical characteristics of the two inflation types^[15]

In table 1 the characteristics of both inflation types are summarized. The similarities according to the monetary system and lost trust in the currency call for similar solutions that will be described in the next passage. The main difference between the two types is the central control over prices and exchange rate that carefully need to be changed over to free market prices and free exchange rates.

2.3. The reform bundle for advanced open inflation

A monetary reform has to be well prepared. Every failure could lead to further inflation and less success chances in the next reform attempt. The economic costs of the inflation increase with time. That is why a monetary reform should be enacted as soon as possible and preferably as a complete bundle of monetary and political measures. Unfortunately, the governments seldom recognize early enough during the inflation process that there is no other way out. The longer it takes to enact the reform the higher are the costs that occur when the reform is finally implemented. These losses in employment, output and distribution should be minimized.^[16]

There are two possible ways to end the expanding money supply: a gradual reduction of circulating money through different kinds of measures or the shock therapy with a drastic currency cut.

The first option is politically easy to start but needs a long period of contracting monetary policy, like liquidity absorbent bonds and taxes. The state has to run budget surpluses and to devalue this surplus which is politically hard to achieve.

The other option seems to be more severe at the beginning but seems to be more successful. The currency cut has to be hard enough to reduce the money supply to an adequate level. If the cut is too little, the reform as a whole might fail. If the cut is too massive, it does not harm the success of the reform bundle. I will come back on how to find out about the necessary amount of currency cut in chapter 5. The economic losses seem to be lower with the shock therapy than with gradualism. Additionally, the drastic and irrevocable currency cut symbolizes a turn in policy and supports the acceptance and trust in the reform as a whole. This is why Bähr names the shock therapy the option of choice.^[17]

The first graph of Figure 1 shows the development of inflation rate over time. Without any actions the inflation rate would increase continuously (T). The inflation rate is estimated to decrease after the enactment point of time (ts) of gradual reform measures (G). Inflation rate would decrease more drastic with shock therapy (S). The consequences for output are linked to the inflation rate: Decreases in inflation rate are favorable for the economy and necessary for output recovery in the long-run.

The economic difference between gradualism and shock therapy is shown in the second graph. The output is shrinking over time without reforms (T). Both reforms result in additional costs at the beginning and recovery of output production later on. A shock therapy (S) leads to stronger pronounced decrease and increase in a shorter time span compared to gradualism (G).

Although reform costs are higher, one can derive a general advantage of shock therapy from the graph because of faster recovery of economy.

[...]

^[1] Cp. Bähr (1994), p. 2f.

^[2] The reform of 1990 has been limited to the eastern, former Soviet part of Germany.

The German monetary reform of 1871 does not have the character of a reconstructing monetary reform; in fact it can be seen as a unifying reform without any measures that reduced real money supply.

^[3] Cp. Bähr (1994), p. 10.

^[4] The literature differentiates between the monetary reform in a narrower sense (pure monetary measures) and the monetary reform in a broader sense (including additional political and institutional measures); cp. Bähr (1994), p. 15.

^[5] Bähr names four examples for partial reforms: 1) monetary-technical events like the elimination of zeros; 2) pure replacement of coins and bank notes; 3) transition from suppressed to open inflation; 4) substitution of domestic money through foreign money (currency substitution); cp. Bähr (1994), p. 11.

^[6] Cp. Bähr (1994), p. 17.

^[7] Cp. Jarchow (2003), p. 1ff.

^[8] At the beginning of an inflationary process the real money stock [MR = MN (nominal money stock) / P (price level)] increases, because the nominal money stock increases faster than the price level. Over the elapse of time individuals increase their expectancy of inflation and the real money stock shrinks. At the state of an advanced open inflation the real money stock decreases below the pre-inflationary level; cp. Bähr (1994), p. 20ff.

^[9] For further comments: Bähr (1994), p. 31ff.

^[10] For this paragraph cp. Bähr (1994), p. 18ff.

^[11] Cp. Bähr (1994), p. 37ff.

^[12] Cp. Bähr (1994), p. 97ff.

^[13] Cp. Bähr (1994), p. 99.

^[14] Cp. Bähr (1994), p. 111ff.

^[15] Characteristics taken from Bähr (1994), p. 176.

^[16] Cp. Bähr (1994), p. 46ff.

^[17] Cp. Bähr (1994), p. 50ff.