The Ends of Four Big Inflations

This paper studies the abrupt endings of four hyperinflations that struck Austria, Hungary, Poland, and Germany in the years following World War I, using them as historical “laboratories” for testing the rational-expectations view of inflation against a rival “momentum” view. The momentum view holds that once high inflation becomes embedded in expectations, only a long, gradual, and costly disinflation – with substantial lost output – can bring it down; a contemporary estimate cited in the paper put the cost to the United States at 220 billion dollars of foregone annual GNP for every one-percentage-point reduction in inflation achieved through restrictive policy. The rational-expectations view, by contrast, holds that current high expected inflation reflects the public’s correct reading of the government’s current and prospective monetary and fiscal policy, so that a sufficiently binding, credible change in that policy – a change in regime rather than an isolated restrictive action – can bring expected and actual inflation down quickly and at much lower cost. Each of the four countries ran enormous, persistent budget deficits financed by having the central bank discount treasury bills and expand its note issue at rates that produced monthly, and at times near-daily, price increases; the paper documents this dynamic country by country, drawing on official League of Nations and U.S. Senate compilations of budget, money-supply, price, and exchange-rate data. In every country the hyperinflation ended suddenly, not gradually, once the government simultaneously created or reconstituted an independent central bank legally forbidden from extending further unsecured credit to the government, and moved decisively toward a balanced budget, typically under the supervision of a League of Nations-appointed Commissioner General and backed by an international reconstruction loan. Sargent argues that it was this credible, coordinated regime change – not simply a reduction in the rate of money creation – that stabilized prices and exchange rates within weeks, because it changed the fiscal backing of government notes from worthless treasury paper to gold, foreign exchange, and commercial assets. The paper further shows that in each country the nominal stock of high-powered money continued to grow rapidly, sometimes multiplying several-fold, in the months after stabilization, a fact Sargent reconciles with the quantity theory by distinguishing “backed” from “unbacked” money. Available unemployment data show that stabilization was accompanied by increases in unemployment that Sargent characterizes as comparatively minor next to the “220 billion dollar” tradeoff invoked in contemporary U.S. debate, though he is careful to note that how much of the recorded unemployment reflects the stabilization itself, as opposed to other real dislocations, “cannot be determined.” As a further comparison case, the paper describes Czechoslovakia, which under Finance Minister Alois Rasin adopted a restrictive fiscal and monetary regime immediately after the war and thereby avoided hyperinflation altogether. Sargent concludes that the essential common ingredients ending each hyperinflation were the joint, coordinated creation of a fiscally independent central bank and a credible commitment to balance the budget, and that – while he acknowledges a deeper objection to whether “regime change” is even a coherent concept within a fully rational-expectations model – the four episodes together constitute unusually clean natural experiments in the effects of credible policy commitment on the expected cost of ending inflation.

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The Ends of Four Big Inflations