Inflating Away the Debt: The Debt-Inflation Channel of German Hyperinflation

Markus Brunnermeier, Sergio Correia, Stephan Luck, Emil Verner, and Tom Zimmermann

The current rise in value pressures all over the world has reignited curiosity in understanding how inflation transmits to the true economic system. Economists have lengthy acknowledged that sudden surges of inflation can redistribute wealth from collectors to debtors when debt contracts are written in nominal phrases (see, for instance, Fisher 1933). If debtors are financially constrained, this redistribution can have an effect on actual financial exercise by enjoyable financing constraints. This mechanism, which we name the debt-inflation channel, is nicely understood theoretically (for instance, Gomes, Jermann, and Schmid 2016), however there may be restricted empirical proof to substantiate it. On this submit, we focus on new insights from one of many key occasions in financial historical past: the Nice German Inflation of 1919-23. As a result of this case of inflation was each stunning and very excessive, Germany’s expertise helps make clear how excessive inflation impacts corporations’ financial exercise by means of the erosion of their nominal debt burdens. These insights are based mostly on a just lately launched analysis paper.

The German (Hyper)inflation

Germany’s bout of hyperinflation is a defining occasion in financial historical past. From a worth of 4.2 per greenback on the eve of World Struggle I, the mark depreciated to 4.2 trillion per greenback by November 1923. This episode has fascinated generations of economists, who’ve studied it to know each the causes and penalties of excessive inflation.

Germany’s inflationary spiral may be divided into two distinct phases. The chart beneath reveals that evolution of the worth degree for each wholesale costs and the cost-of-living index. The primary part of the inflation, from November 1918 to June 1922, introduced a considerable rise within the value degree as a result of numerous components, together with deficit-financed struggle spending, huge World Struggle I reparations, and political unwillingness to boost taxes and minimize spending. The absence of a proactive central financial institution response exacerbated the inflation. Notably, information on the ahead trade premium and anecdotal proof of overseas speculators betting on an appreciation of the mark counsel that inflation was largely sudden throughout this part. The second part, from July 1922 to November 1923, was the hyperinflation part. This part begins after political turmoil over World Struggle I reparations and the assassination of Walther Rathenau, the nation’s distinguished overseas minister. Hyperinflation is characterised by uncontrollable value will increase and unanchored inflation expectations.

The Worth Degree throughout Germany’s Inflation

Supply: The wholesale value index (Gesamtindex der Grosshandelspreise) and cost-of-living index (Lebenshaltung insgesamt) are from Zahlen zur Geldentwertung in Deutschland von 1914 bis 1923.
Notes: This chart reveals the evolution of the worth degree in Germany between January 1914 and June 1924. The fee-of-living index solely obtainable from February 1920 onwards. Because of the excessive modifications in value ranges, costs are reported in logarithms and over two axes, with the primary part of the inflation on the left axis and the second part on the fitting axis.

Germany’s inflation was related to a booming economic system from 1919 by means of the center of 1922, adopted by a extreme bust beginning on the finish of 1922. The chart beneath plots an index of annual actual GDP per capita for Germany beginning in 1918. For comparability, we additionally plot an index of common actual GDP per capita development for different main industrial economies. Whereas these economies skilled declining output from tight financial situations, Germany’s actual GDP per capita rose by 20 % from 1919 to 1922. Additional, unemployment was low from the tip of WWI till the final months of 1922. Germany’s  growth slows with the hyperinflation within the second half of 1922 and decisively reverses in early 1923, following the invasion of the Ruhr industrial area by France and Belgium. In 1923, Germany noticed a big fall in actual GDP, and unemployment rose to just about 30 %.

Actual GDP in Germany and Different Main Economies, 1918-27

Sources: Jordà et al. (2017); Barro and Ursúa (2008).
Notes: This chart reveals actual GDP per capita for Germany and an index of different main economies. The sequence are listed to 100 in 1918. “Main economies excluding Germany” is an index of common actual GDP development per capita, weighted by lagged nominal GDP in U.S. {dollars}. The index is constructed utilizing 15 international locations with steady protection within the Jordà et al. (2017) database between 1914 and 1927 (Australia, Belgium, Canada, Denmark, Finland, France, Italy, Japan, Norway, Portugal, Spain, Sweden, Switzerland, the U.Ok., and the U.S.).

Empirical Proof of the Debt-Inflation Channel

What are the macro-financial implications of inflation? To discover the empirical relevance of the debt-inflation channel, we assemble a brand new firm-level database by digitizing a recent investor’s guide with data on corporations’ monetary statements and employment. The information cowl roughly 700 nonfinancial joint-stock corporations in Germany. These information reveal that inflation massively devalued corporations’ liabilities, leading to a collapse in agency leverage (outlined because the ratio of nominal liabilities to property). The chart beneath reveals that leverage fell by over 50 % between the beginning of the inflation in 1919 and the aftermath of the inflation in 1924.

Inflation Wiped Out Agency Leverage

Supply: Saling’s Börsen-Jahrbuch.
Notes: This chart reveals the distribution of agency guide leverage (liabilities-to-assets) in the beginning of the postwar inflation in 1919 and within the aftermath of the hyperinflation in 1924.

The discount in corporations’ nominal liabilities considerably diminished the chance of economic misery for corporations in Germany. The subsequent chart plots bankruptcies in opposition to inflation, revealing a powerful detrimental relation between the 2 variables. Bankruptcies persistently declined with rising inflation and remained at traditionally low ranges, even with the financial tumult of 1923. The sharpest declines in bankruptcies occurred within the first part of excessive inflation, earlier than the hyperinflation in 1922-23. In the course of the hyperinflation, further inflation solely barely diminished bankruptcies. Intuitively, as soon as the worth degree has doubled a number of occasions inside a number of years, money owed have already been worn out, making chapter more and more unlikely.

Inflation and Agency Bankruptcies

Sources: Vierteljahrshefte zur Statistik des Deutschen Reichs Herausgegeben vom Statistischen Reichsamt; Zahlen zur Geldentwertung.
Notes: This chart plots the variety of agency bankruptcies in quarter t in opposition to realized inflation over the previous 4 quarters from t − 4 to t. Inflation is calculated because the log change (occasions 100). Quarterly counts of agency bankruptcies are obtained from the Vierteljahrshefte zur Statistik des Deutschen Reichs Herausgegeben vom Statistischen Reichsamt. Inflation of wholesale costs as reported in Zahlen zur Geldentwertung. The thick traces signify quadratic suits, computed individually for every of the 2 phases of inflation.

To know the influence of inflation on actual financial exercise on the agency degree, we look at the cross-section of corporations based mostly on their leverage previous to the inflationary shock. Corporations with increased leverage earlier than the onset of inflation noticed the most important discount in actual debt burdens. Due to this fact, if the debt-inflation channel impacts actual exercise, then it ought to function most strongly for these high-leverage corporations.

The information help this speculation. We discover that high-leverage corporations skilled bigger declines in curiosity bills and relative will increase in each guide and market fairness values. Furthermore, these corporations expanded their actual exercise. The chart beneath reveals the employment dynamics for low, intermediate, and excessive leverage corporations through the inflation. It reveals that top leverage corporations noticed the quickest employment development as soon as inflation accelerated in 1919. By way of magnitudes, the debt-inflation channel can account for almost all of the general enlargement in employment through the German excessive inflation episode.

Employment Dynamics throughout Low and Excessive Leverage Corporations

Supply: Saling’s Börsen-Jahrbuch.
Notes: This chart presents the typical cumulated development of employment for corporations within the backside, center, and high terciles of leverage. Leverage is outlined as the typical ratio of liabilities-to-assets over 1918-1919. Employment is listed to 100 in 1918 for every group.

Wrapping Up

By exploiting a newly digitized firm-level database, our analysis supplies empirical proof supporting the relevance of the debt-inflation channel within the transmission of sudden inflation to the true economic system. What are the broader implications of those findings? Can the debt-inflation channel be operative throughout occasions of reasonable inflation?

The relevance of the debt-inflation channel relies on the construction of debt contracts. In circumstances the place debt contracts are nominal, long-term, and denominated in home foreign money, the debt-inflation channel could also be related even throughout extra reasonable bouts of inflation. The debt-inflation channel might also function by means of households, particularly in a context of fixed-rate, long-term mortgage debt, as instructed in present educational work corresponding to Doepke and Schneider (2006). On the identical time, for corporations with floating-rate or foreign-currency debt, inflation could have impartial and even detrimental results on closely leveraged corporations.

Different components can even counteract the expansionary results of the debt-inflation channel. One instance is that if financial coverage responds to rising inflation by rising rates of interest and tightening monetary situations. One other doubtlessly necessary offsetting impact comes from the losers of the debt-inflation channel: collectors. A rise in inflation can erode financial institution fairness and contribute to credit score contraction that offsets the expansionary impact from decreasing borrower debt burdens.

Markus Brunnermeier is a professor of economics at Princeton College and director of Princeton’s Bendheim Heart for Finance.

Emil Verner is the Class of 1957 Profession Improvement Professor and an assistant professor of finance on the MIT Sloan College of Administration.

Tom Zimmerman is a professor for information analytics in economics and finance on the College of Cologne.

The way to cite this submit:
Markus Brunnermeier, Sergio Correia, Stephan Luck, Emil Verner, and Tom Zimmermann, “Inflating Away the Debt: The Debt-Inflation Channel of German Hyperinflation,” Federal Reserve Financial institution of New York Liberty Avenue Economics, July 13, 2023, https://libertystreeteconomics.newyorkfed.org/2023/07/inflating-away-the-debt-the-debt-inflation-channel-of-german-hyperinflation/.