Is it 1932 – or 1923?

By Martin Hutchinson
Contributing Editor
Money Morning

Endless reports in the media have pointed out that this global recession is "worse than anything since the Great Depression."

To be fair, it's not even certain yet that this nasty downturn has beaten the mid-1970s downturn, though it probably will. But even if that does happen, by focusing exclusively on the 25% unemployment of the 1930s and the "Grapes of Wrath" Joad family as our inevitable future, we're ignoring another equally unpleasant potential scenario: The Weimar German hyperinflation of 1923.

The U.S. authorities and those of the G-20 are currently avoiding most of the mistakes that during the period from 1930 to 1932 turned an ordinary recession into the Great Depression. In those years, the U.S. Federal Reserve deflated the money supply by about 30% in real terms. Central bank officials didn't realize they were doing this; banks kept failing, thus reducing the country's bank deposits, while the Fed did nothing to offset the money supply shrinkage the bank failures produced.

U.S. President Herbert Hoover raised tariffs via the Smoot-Hawley Tariff Act of 1930, causing world trade to fall by 65%; his huge income tax increase (with the top rate going from 25% to 63%) in 1932 also contributed greatly to the global economic meltdown. All three mistakes have been avoided this time:

  • The money supply has expanded rapidly, bringing negative real interest rates almost everywhere except Brazil.
  • And fiscal policies have been expansionary and protectionism limited.

The history of the Weimar German inflation was quite different. During World War I, Germany ran moderate inflation, which accelerated in the last year of war and the first years of peace. By 1921, prices in Germany were already 15 times those of 1914.

But it was over the next two years - 1921 to 1923 - that true "Weimar inflation" occurred. By the time it ended in November 1923, the German mark was worth only one-trillionth of what it had been worth back in 1914. The middle classes lost all their savings, but one rich industrialist, Hugo Stinnes, was able though repeated borrowing in rapidly depleting marks to amass an industrial empire that controlled 20% of Germany's industry.

The German hyperinflation was finally quelled by Chancellor Gustav Stresemann and Reichsbank director Hjalmar Schacht, who in October 1923 announced the replacement of the paper mark by a "Rentenmark" (security mark) worth 1 trillion paper marks and backed by a nominal mortgage over German land assets worth 3.2 billion Rentenmarks.

The mortgage was fictitious, but it created confidence in the Rentenmark and prevented the creation of extra Rentenmarks, so inflation rapidly ceased, while the budget was balanced through so-called "windfall-gains taxes" on debtors whose debts had been extinguished by the previous hyperinflation. Normal business was resumed by Germany, which was able to return to a new gold Reichsmark in July 1924.

You can debate which was worse, the U.S. Great Depression or the Weimar hyperinflation; there are arguments for both sides. The Great Depression lasted much longer, from 1929 until the United States entered World War II in 1941. On the other hand, the Weimar hyperinflation wiped out the entire savings of the German middle class.

The lack of confidence in the economy, and the overall misery that this produced, meant that the German reaction to the Great Depression that arrived six years later was much more extreme than in the United States - leading to the election in 1933 of Adolf Hitler.

The current policy mix reflects those of Germany during the period between 1919 and 1923.  The Weimar government was unwilling to raise taxes to fund post-war reconstruction and war-reparations payments, and so it ran large budget deficits. It kept interest rates far below inflation, expanding money supply rapidly and raising 50% of government spending through seigniorage (printing money and living off the profits from issuing it).

Even John Maynard Keynes, no monetarist, recognized the problems with this, stating in his 1920 treatise the "Economic Consequences of the Peace" that "the inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance."

The really chilling parallel is that the United States, Britain and Japan have now taken to funding their budget deficits through seigniorage. In the United States, the Fed is buying $300 billion worth of U.S. Treasury bonds (T-bonds) over a six-month period, a rate of $600 billion per annum, 15% of federal spending of $4 trillion. In Britain, the Bank of England (BOE) is buying 75 billion pounds of gilts over three months. That's 300 billion pounds per annum, 65% of British government spending of 454 billion pounds. Thus, while the United States is approaching Weimar German policy (50% of spending) quite rapidly, Britain has already overtaken it!

U.S. authorities probably won't pursue expansionary monetary policies with quite the dogged Germanic persistence that caused the mark to fall to one trillionth of its former value. However, the turnaround needed to stop a Weimar repetition will be very unpleasant, so there will undoubtedly be considerable denial and fudging of the figures as inflation begins to take off (especially if Ben S. "Drop Money From Helicopters" Bernanke is still serving as the head of the U.S. central bank).

As investors, we need to ensure that our money is safe from the inflationist onslaught. Our portfolio should thus currently contain no bonds - even Treasury Inflation Protected Securities (TIPS) are linked to the U.S. consumer price index (CPI), which has been fiddled before and will be again, so will not provide true inflation protection.

Only gold will play its traditional role as a protector of savings against inflationary onslaught. Once policymakers get serious, gold prices will drop, as inflation risks recede. But before that gold prices are likely to shoot much higher, perhaps beyond their 1980 peak of $2,300 in today's dollars. You have to remember that gold is a thin market, with only $100 billion mined annually, so a surge of hedge funds into the gold market could move the price very quickly indeed.

Two avenues into gold should be attractive, the SPDR Gold Shares ETF (GLD) which invests in gold directly and the more financially solid gold mining companies, such as Barrick Gold Corp. (ABX) and Yamana Gold Inc. (AUY). Since gold has fallen back recently to below $900 an ounce, it may be a good time to buy.

[Editor's Note: When it comes to banking or global economics, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson, who brings to the table the kind of high-level expertise that our readers have come to expect. Fans and followers of Hutchinson's work will soon be able to subscribe to a new product - The Permanent Wealth Investor - that will feature more of his expertise. Watch for The Permanent Wealth Investor to debut in the next week.]

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