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"Weimar on the Volga": Causes and Consequences of Inflation in 1990s Russia Compared with1920s GermanyAuthor(s): Niall Ferguson and Brigitte GranvilleSource: The Journal of Economic History, Vol. 60, No. 4 (Dec., 2000), pp. 1061-1087Published by: Cambridge University Press on behalf of the Economic History AssociationStable URL: http://www.jstor.org/stable/2698087Accessed: 17/08/2010 15:12

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" Weimar on the Volga ": Causes and Consequences of Inflation in 1990s Russia

Compared with 1920s Germany NIALL FERGUSON AND BRIGITTE GRANVILLE

This article offers a comparative analysis of the inflationary experiences of Weimar Germany and post-Soviet Russia, applying theories about money and govermment budget constraints in the manner of Thomas Sargent and Francois Velde. The comparison looks beyond economic policy itself to the political and social consequences ofthe two inflationary crises. The parallel is fairly close: close enough to suggest that Russia, despite its recent quiescence, may not have seen the end of its monetary-or political-travails.

The idea that inflation fatally weakened the Weimar Republic retains a special place in both economic and political history. Ever since the

events themselves, it has frequently been asserted that inflation benefited only a few profiteering industrialists while stripping the middle class of its savings, and that this expropriation contributed significantly to the rise of Hitler.! The counterargument, also advanced at the time and subsequently echoed by numerous scholars, is that inflationary policies boosted employment, and indeed were the only means of averting even greater social and political instability.2 Economic historians of this more "Keynesian" bent have tended to blame the deflationary policies pursued after 1929 for the collapse of democracy into the National Socialist dictatorship.3 The most recent scholarship has cast doubt on these latter arguments. Costantino Bresciani-Turroni's early critique, to the effect that inflation succeeded only in postponing a postwar recession, and then only at great cost to the middle class, has been substantially vindicated by the work of Gerald Feldman and others.4 Although it is simplistic to draw a direct line of causation from the

The Journal of Economic History, Vol. 60, No. 4 (Dec. 2000). C The Economic History Association. All rights reserved. ISSN 0022-0507.

Niall Ferguson is Professor of Political and Financial History, Jesus College, Oxford OXI 3DW, U.K. E-mail: [email protected]. Dr. Brigitte Granville is Head of the International Economics Programme, The Royal Institute of International Affairs, 10 St James's Square, London SW 1 Y4LE, U.K. E-mail: [email protected].

This article draws on material originally contained in Ferguson and Granville, "Sovremennaia Rocciia." We gratefully acknowledge the comments by three anonymous referees. We have also benefited from comments by Forrest Capie, Judith Shapiro, and Christopher Granville.

' See the classic account by Bresciani-Turroni, Economics of Inflation; for a summary of the literature, see Ferguson, Paper, pp. 1-30.

2 Graham, Exchange; Laursen and Pedersen, German Inflation; and Holtfrerich, German Inflation. 3 For useful summaries of the debate see Kershaw, ed., Weimar; and Kruedener, ed., Economic Crisis. 4 Bresciani-Turroni, Economics ofInflation; and Feldman's GreatDisorder, in many ways the culmina-

tion of a sustained collective research effort. For full bibliographical details see Ferguson, "Constraints."

1061

1062 Ferguson and Granville

inflation to Hitler, it is nevertheless clear that inflation caused profound, and ultimately fatal, damage to the Weimar system. It gravely weakened the German capital market: fears of a second inflation pushed up public-sector bond yields in the mid- 1920s, squeezing local government investment and ruling out large-scale deficit finance as a response to the slump beginning in 1928.5 Its drastic redistributional effects alienated a wide range of social groups, and not only those who emerged as net losers.6 Significantly, one of Hitler's pledges to voters was to "see to it that prices remain stable. That's what my stormtroopers are for. Woe to those who raise prices.... Nothing similar will happen a second time."7

Somewhat similar arguments have been made for and against inflationary policies in post-Soviet Russia. Deficit finance, by monetary expansion or bond issue, has been justified as a way of avoiding high unemployment. But the weight of scholarly opinion now holds that in Russia, as in Weimar Germany, inflation's costs have outweighed whatever short-term macroeconomic benefits it may have offered. Expansionary fiscal and monetary policies have led to high inflation and ultimately to debt default. At the same time, inflation has exacted a high social cost, with potentially destabilizing political consequences.8

Of course, Weimar Germany is only one of many case studies in fiscal and monetary instability with which contemporary Russia could usefully be compared, such as the Habsburg successor states after 191 8,9 or the more recent Latin American inflations.'0 But so many observers in the 1 990s drew a parallel between Weimar and Russia (The Economist, for instance, first evoked "Weimar on the Volga" as early as 1993) that it seems worthwhile to compare them systematically.11

This study draws on Thomas Sargent and Francois Velde's explanation of the macroeconomic features of the French Revolution.'2 It therefore follows closely Sargent and Neil Wallace's "unpleasant monetarist arithmetic," which emphasizes the restrictions imposed on government deficits and debt by budget constraints and compound interest. In their model, permanently higher budget deficits must eventually be accommodated by increases in the monetary base, given a real rate of economic growth below the real rate of interest. 13

'Balderston, German Economic Crisis; and Borchardt, "Gewicht der Inflationsangst." 6Hughes, Payingfor the German Inflation; and Ferguson, Paper, pp. 419-33. 7Feldman, Great Disorder, p. 855. 8 Granville et al., "Less Inflation." 9 See for instance Sargent, "Ends." 10 See Capie, "Conditions." " For a review of the literature comparing Russia with Weimar, see Hanson and Kopstein, "Weimar/

Russia Comparison." 12 Sargent and Velde, "Macroeconomic Features." 13 Sargent and Wallace, "Some Unpleasant Monetarist Arithmetic."

"Weimar on the Volga" 1063

In both 1920s Germany and 1990s Russia, the public budget constraint was tight. The early Weimar governments ran annual deficits of well above 10 percent of net national product (NNP); post-Soviet Russia's deficits were of a similar order. Just as in Germany, the Russian state's flair for industrial subsidy was not matched by its ability to collect taxes: weak governments and strong lobbies were a recipe for red ink. In the German case, the burden of reparations weighed heavily on the balance of payments. In the Russian case, the external debt inherited from the Soviet Union, and the failure of international lending agencies in 1992 to provide balance-of-payments support, created roughly analogous problems. Monetary financing was replaced in 1995 by bond financing, leading to the chain of events predicted by Sargent and Wallace. The favorable markets of 1996/97 could have been used to provide convenient bridging finance for a rapid fiscal adjustment, rather as might have been achieved also in Germany in 1920/21. Instead, the Russian government (once again like Weimar' s) regarded rising bond prices as offering further opportunities to leverage itself. There is thus a clear parallel between Germany's default on reparations in 1922 and Russia's debt default of 1998.

The German inflation ended only with the balancing of the budget in 1924, which persuaded holders of the new dollar-pegged currency (and foreign investors) that a genuine "regime change" had taken place. Here the parallel breaks down, for Russia, despite the longer duration of its crisis, has yet to establish a definitive fiscal and monetary stabilization.

INSTITUTIONAL AND POLITICAL BACKGROUND

Defects of fiscal policy cannot be understood without reference to domestic political circumstances. In both countries, the weaknesses of a new democracy and its institutions, and the ambivalence ofthe elite, impeded effective fiscal reforms.

The Weimar Institutional and Political Framework

The Weimar Republic was the product of military defeat and revolution. The unexpected collapse of the defacto military dictatorship following the German military reverses on the Western Front in August 1918 precipitated a revolution on the "home front." As military discipline crumbled, a wave of strikes paralyzed the economy. Prince Max of Baden announced the Kai- ser' s abdication and handed over the office of Reich Chancellor to the Social Democrat leader Friedrich Ebert; another Social Democrat, Philipp Scheidemann, proclaimed a republic. The Social Democrat members of the new Council of People's Deputies recast the old parliamentary structures of


the Reich, rejecting calls from the left for a Soviet-style political transforma- tion. Instead, pragmatic agreements were reached with representatives of German industry and the army. A National Assembly, elected in early 1919 and convening in the relative tranquility of Weimar, drew up a new constitution that replaced the Kaiser with a popularly elected president and made the federal government accountable to the democratically elected parliament, the Reichstag. The Reich states (which lost some of their powers to the central government and became mere Liinder or "lands") were likewise democra- tized, as were local authorities.14 Thus, although there was considerable administrative continuity from the old regime to the new, fiscal decisions were now in the hands of elected assemblies at all three levels.

The parties of the so-called "Weimar coalition"-Social Democrats, Left Liberals, and the Catholic Center-fared badly at the first elections under the new system in June 1920, which saw gains by the Communists and the Right. Both political extremes exerted strong, extraparliamentary pressures throughout the period from 1919 to 1923. Right-wing elements in the army and civil service, supported by a fragmented protofascist movement, called for a more authoritarian system and launched putsch attempts in 1920 and 1923. The assassination of the leading liberal politicians Matthias Erzberger and Walther Rathenau also served to undermine political stability. The far left resorted to violence as well: there were abortive "actions" and "risings" in 1919, 1921, and 1923.

With industrial unrest reaching unprecedented levels in 1919 and re- maining high until 1923, economic policy was especially susceptible to demands for "socialization." After much debate, works' councils within large firms were granted limited powers. In addition, a Reich Economic Council was created as a kind of corporate parliament of economic inter- ests alongside the Reichstag. And state economic intervention-which had already increased enormously during the war-was allowed to continue into peacetime. Price controls, rent controls, exchange controls, and trade controls, all of which had been introduced piecemeal in wartime, were to some extent continued in modified forms. At the same time, wages-especially in industries employing large numbers of workers-were now sub- ject to national collective agreements; if these broke down there were appeals, sometimes heeded, for state arbitration. Although the highly centralized bodies that had been responsible in wartime for allocating raw materials ceased to exist, and the industrial cartels that had controlled production, prices, and exports were significantly weakened, business associations continued to play a direct or indirect role in the political pro- cess, as did labor organizations. These various "corporatist" organizations

14 Kolb, "Internationale Rahmenbedingungen"; Kluge, Deutsche Revolution; Winkler, "Revolution"; and Bessel, Germany.


and institutions greatly complicated economic policymaking and gave heavy-industrial interest groups considerable influence.'5

Immediately after November 1918, the German Demobilization Commis- sion's principal concern was to ensure that returning soldiers were quickly absorbed into the civilian workforce, and throughout the inflation years the government paid generous subsidies to maintain employment levels. Aver- age unemployment was kept low: 3.7 percent in 1919, 3.8 percent in 1920, 2.8 percent in 1921, and 1.5 percent in 1922. Only in 1923 did it reach a level (10.2 percent) comparable with that experienced in Britain in the same period.16 Around 12 billion marks were spent in the fiscal years 1919 and 1920 on shipbuilding programs, the primary aim of which was job-creation. 17 The railway system was also directed to absorb surplus labor. As late as 1923 finns were reluctant to lay off employees, preferring to keep them on part-time. On average, 27.8 percent of trade union members were on "short time" in 1923, so the level of spare capacity in the economy was much higher than the unemployment data would suggest.

The Russian Institutional and Political Framework

As in the German case, so too the Russian story begins with a revolution- ary change in the political system, which nevertheless preserved important elements of the old regime. On 12 June 1990 the Russian Soviet Federative Socialist Republic (RSFSR) was proclaimed a sovereign state, and exactly one year later Boris Yeltsin was elected its president. Following the failed coup of August 1991, the keystone of the old order was removed with the dissolution of the Communist Party of the Soviet Union (CPSU). The Soviet Union itself was formally pronounced dead on 8 December 1991. Despite these deep political transformations Russia nevertheless inherited the 1977 Soviet constitution. By now this Brezhnev-era text had been much amended; in particular, a directly elected presidency and various human rights provi- sions had been written in. But in its essentials it remained a firmly Soviet document, above all in its explicit denial of any separation of powers: Arti- cle 104 stated that virtually all matters fell within the competence of the Congress of People's Deputies. That body had been last elected in February 1990, at a time when the CPSU still had effective control of the country. This gave an extremely powerful instrument to the opponents of reform as

'5Maier, Recasting Bourgeois Europe; Feldman, Iron and Steel and Great Disorder. 16 Bry, Wages in Germany, pp. 398-402. These figures are not based on a modem definition of

unemployment, but are percentages of total trade-union membership. As such, they may conceal unemployment in sectors (notably commerce and agriculture) where unionization rates were low. On the other hand, German trade union membership was exceptionally high in this period, so the figures are less misleading than might be supposed.

" Ferguson, Paper, pp. 280ff.


long as the old constitution remained in force, which it did until late 1993. One such opponent was the Union of Russian Industrialists and Entrepre- neurs, which represented the managerial elite of the old planned economy; it and its like claimed that the liberalizing policies of Yegor Gaidar's government were destroying the country's industrial base. And indeed, the industrial lobby did much to subvert reform. The fact that enterprises remained largely responsible for social expenditures (housing, kindergartens, medical care, and much else), as well as unemployment insurance, helped them obtain large subsidies. 18 As in Weimar Germany, industrial policy thus became a species of employment policy. As a result, during the period 1992-1998 registered unemployment remained between 1. 1 and 2.6 percent of the labor force.'9 Under the International Labor Organization (ILO) definition, it varied between 4.8 and 11.9 percent for the same period. But whatever definition is used, employment clearly fell by less than the 50 percent decline in real GDP since 1989 (Figure 1).

Low unemployment figures, however, concealed dramatically falling labor productivity. Moreover, widespread wage default meant that many jobs were in fact fictitious.20 The power of the new economic elite-the so-called oligarchs-added seriously to the problem since they controlled about 70 percent of the tax base. Besides using their political connections to grab assets, they used the resulting wealth to corrupt senior officials and thus to place themselves above the law, especially with regard to tax compliance.21

Other forces frequently cited to explain Russia's macroeconomic instability are cultural as much as political: in particular the moral, social, and institutional wreckage left by the Soviet system. Corruption and tax evasion are often seen as part of this post-Soviet moral crisis. But as numerous contemporary commentators attested, post-World War I Germany was also rife with corruption, tax evasion, and crime, despite Imperial Germany's reputa- tion for public probity.22 There is good reason to see these phenomena as symptoms rather than causes of the underlying institutional problems. A simultaneous breakdown of public finance and the monetary system tends to undermine both the rule of law and the norms of civil society, by weaken- ing the incentives for individuals to obey them. Civil servants whose real salaries have been eroded by inflation, or have not been paid at all, will be likelier to accept bribes; entrepreneurs faced with high nominal tax rates but weak collection mechanisms will be tempted to evade; and gangsters will

18 Boycko and Shleifer, "Russian Restructuring." 19 The Russian definition excludes all job seekers who have an alternative sources of income, such

as students and pensioners. 20 Commander and Tolstopiatenko, "Characteristics." 21 See Granville, C., "Political Environment." 22 Ferguson, Paper, pp. 430-33; and Feldman, Great Disorder, pp. 555-75.


15 Real GDP (annual percent change)

1. - Unemployment Rate (Registered) -

- Unemployment Rate (ILO)

5 1 - ~~~~~................... 5 -

0 -

FIGURE I

RUSSIA: PEAL GDP CHANGE AND UNEMPLOYM ENT 1990}1998 (Percentaae, annual)

Sozirce: Goskomstat.

take the place of the police and courts in resolving private disputes. That two societies as different as Imperial Germany and Soviet Russia could succumb to these maladies wvithin j'ust a few years of a political regime change sug- gests that they are due as much to defective policies as to moral decadence.

GOVERNMENT BUDGET CONSTRAINTS

Both Weimar Germany and post-Soviet Russia were burdened by a high ratio of debt service to fiscal revenues. But in neither case did the government act on the ratio' s denominator (fiscal revenues), always on the numera- tor (debt service). In other words, default-in 1922 for the former, 1998 for the latter-was the preferred way out.

The Weimar Budget Constraint

As a result of the First World War, German public spending had risen from around 14.5 percent of NNP to a 1917 peak of 77 percent. The bulk of additional spending was financed by domestic borrowing. After the war, the


budget deficit remained large. Total Reich spending in 1919 was around 40 percent lower than in 1918, reducing the state's share of NNP from 64 percent to 43 percent;23 but Reich revenue had fallen by 50 percent, so that the government deficit rose by some 24 billion marks, or 173 percent.24 The result was a 44 percent increase in the floating debt. The tax reform program introduced by Erzberger in 1919/20 was largely unsuccessful. For the tax reform to work, a major administrative reorganization was required, including increased centralization of the federal tax system. This took time, and inflation could be exploited to reduce the real value of many tax liabilities since taxes were not valorized until late 1923. Income taxpayers outside the withholding tax system applied to wages had a strong incentive to delay payment.25 As a proportion of NNP, the Reich deficit fell from its wartime peak of 58 percent to 18 percent in 1919, but remained excessive thereafter (16 percent in 1920, 12 percent in 1921, and 9 percent in 1922). Though inflation had the effect of reducing the internal debt burden in real terms- War Loans and other domestic debt instruments were denominated not in gold marks but in paper marks-in mid-1921 the internal debt was still equivalent to around 60 percent of NNP.26 The fiscal breakdown reached its climax as a result of the campaign of "passive resistance" to the French occupation of the Ruhr (beginning 11 January 1923). Total public spending rose by more than 75 percent in 1923 compared with the previous year. At the same time real revenues plummeted by 74 percent, giving rise to an unprecedented surge in government borrowing. The total deficit in 1923 was around 22 percent of NNP, the highest figure since 1918 (Figure 2). In all, between 1914 and 1923 only around 16 percent of total real Reich expenditures were met by taxation, and more than half the shortfall was financed by short-term borrowing.27

According to John Maynard Keynes and the majority of German commentators at the time, reparations were the primary cause of inflation in Ger-

y2 many. There is little doubt that the external burden was a heavy one. After two years of inter-Allied haggling, the London Ultimatum of 1921 de- manded a total indemnity of 132 billion gold marks; the initial payment required from Germany was around 3 billion gold marks.29 According to Ger- man budgetary data, total real expenditure under the terms of the Versailles

23 Witt, "Finanzpolitik," pp. 424f. 24Roesler, Finanzpolitik. 25 Sargent, "Ends," p. 69. 26 Gold mark" is the usual expression for the nominal ("paper") mark as deflated by the dollar

exchange rate index to allow for depreciation since July 1914. 27 Bresciani-Turroni, Economics of Inflation. 28 See especially Keynes, Economic Consequences. 29 Schuker, "Finance and Foreign Policy," p. 351; Webb, Hyperinflation, pp. 54, 104f.; Holtfrerich,

"Deutsche Inflation," pp. 148f.; Kent, Spoils of War, pp. 132-38; and Eichengreen, Golden Fetters, pp. 129f.


45

40

35 -Genrany (% of NNP)

30 - 'Russia (% of GDP)

25 - ^

15-

10 "

51 .. ~~ ~ ~~~~~~~~~~~~~~~~~......... 5 -

1919 1920 1921 1922 1923 1924 1992 1993 1994 1995 1996 1997

FIGURE 2

GERMAN AND RUSSIAN CENTRAL-GOVERNMENT BUDGET DEFICITS, 1919-1924 AND 1992-1997

(percentage of NNP/GDP)

Note: For Russia, this is the enlarged public sector deficit defined as federal and local governments, plus extra-budgetary funds, plus unbudgeted import subsidies. Sources: Sommariva and Tullio, German Macroeconomic History, p. 123; Ferguson, Paper and Iron, P. 477; and Goskomstat RF, Kratkosrochnye ekonomicheskie, various issues.

treaty in the years 1920-1923 amounted to between 6.5 and 7.6 billion gold marks, considerably less that the 12 billion gold marks that the Allies had hoped to receive. But this was still a heavy burden, amounting to more than 80 percent of Reich revenue in 1921.3? In purely fiscal terms, reparations payments were roughly equivalent to the deficits run by the Reich in the inflation years.31 Even if one ignores the so-called C-bonds, which were effectively suspended until German exports had recovered significantly, the external burden still amounted to around 100 percent of NNP.32 The annual sum Germany was supposed to transfer after 1921 was equivalent to around 7 percent of estimated 1921 national income, or 77 percent of exports.33

30 Witt, "Finanzpolitik," pp. 425f.; Holtfrerich, German Inflation, pp. 148f.; Webb, Hyperinflation, pp. 33, 37, 108; and Eichengreen, Golden Fetters, p. 146.

31 Ferguson, "Constraints," pp. 646f. 32 Assuming a reparations burden of 50 billion gold marks (the A- and B-bonds), minus the roughly

9 billion gold marks the Germans had already paid in cash and in kind. 33 Calculated from figures in Ferguson, Paper.


In Keynes's view, Germany could not readily achieve a current-account surplus out of which to pay cash reparations, and was therefore obliged to buy hard currency by selling paper marks, thus driving down the exchange rate, pushing up import prices and hence the domestic price level. He and others also saw this as a way of enhancing German diplomatic leverage. In Frank Graham'swords, the view was "by no means withoutjustification that improvement in the public finances would lead to still more severe exac- tions."34 Depreciation (and hence inflation) was, according to Carl-Ludwig Holtferich, "in the national interest"-the most effective way of"persuading the rest of the world of the need for a reduction of the reparations burden."35

On the other hand, Sally Marks, Stephen Schuker, and Bruce Kent have argued that Germany could have stabilized the currency and paid more in reparations, without generating hyperinflation, if the German government had been willing to depress domestic demand sufficiently to generate an export surplus.36 Furthermore, help was available in the form of the large amounts of private foreign lending made during and after the inflation. With export earnings at low levels, the inflow of food and raw materials could onlybe sustained by credits from foreign suppliers. Between 1919 and 1921, German imports from the United States totaled $776 million, according to U.S. figures; Germany's trade deficit with the United States rose from 246 million gold marks in 1919 to 932 million in 1920 and 1,226 million in 1921-almost equivalent to the entire German trade deficit given in the official German statistics. This was financed partly by large-scale trade credits, and partly by numerous small-scale foreign purchases of paper marks. Foreign deposits at the seven largest Berlin banks rose from 13.7 billion paper marks in 1919 to 41.6 billion in 1921, accounting for almost a third of total deposits. Purchases of German currency in New York totaled 60 million gold marks between July 1919 and December 1921. At the same time, mark-denominated bonds became a popular investment. There was a net capital inflow to Germany of around 13 billion gold marks in the years 1919 to 1923, with the lion's share coming in 1919, 1921, and the first half of 1922. In the first months of 1921 the effect of these capital inflows was to fund the trade deficit, stabilize the mark's external value, and stop inflation-creating probably the best opportunity of the period for some kind of enduring stabilization.38

In the middle of 1921, however, depreciation resumed: the mark fell from 62.3 per dollar in May to 262 in November. This was primarily a conse- quence of the flight of German capital, triggered by the London Ultimatum.

34 Graham, Exchange, pp. 4, 7-9, 11, 30-35, 248, 321. 3 Holtfrerich, "Deutsche Inflation," p. 327. 36 Marks, "Myths"; Schuker, "Finance and Foreign Policy"; and Kent, Spoils of War. 37 Webb, Hyperinflation, p. 57. 38 Ferguson, "Constraints."


100

90

80-

70 - - Germany 70 Russia

60 -

50 l

40-

30-

20 - J

10 - -

-10 1

-20

-30-

-40-

-50 Jan. 1919 Jan.1920 Jan. 1921 Jan. 1922 Jan. 1923 Jan. 1924 Jan. 1992 Jan.1993 Jan. 1994 Jan. 1995 Jan. 1996 Jan. 1997 Jan. 1998 Jan. 1999

FIGURE 3 GERMAN AND RUSSIAN EXCHANGE-RATE DEPRECIATION, 1919-1923 AND

1992-1999 (percentage, monthly)

Sources: For Germany: Statistisches Reichsamt, Zahlen zur Geldentwertung, pp. 5, 16f; and Holtfrerich, German Inflation, p. 17. For Russia: Moscow currency-exchange data.

At this stage, Keynes's pessimism about the mark was exceptional among foreign investors, judging by the forward exchange rate in London, and figures for purchases of marks in New York. A last flicker of foreign hope accounts for the temporary halt to depreciation from December 1921 to February 1922. But thereafter the final wave of depreciation struck, especially after the assassination of Foreign Minister Rathenau (24 June 1922). After the initial "learning period" of 1919, domestic prices kept pace with currency depreciation. Public expectations of a complete collapse of the mark were expressed in bouts of rapid depreciation against the dollar (Fig- ure 3), and in roughly synchronized leaps in domestic prices. In view of the large mark-denominated foreign loans that were wiped out by depreciation, Schuker has estimated that American "reparations" to Germany exceeded the official reparations Germany actually paid to the Allies.39

At around a year's NNP at the time of the 1921 London Ultimatum, Wei- mar's external burden was heavy; but not quite as impossible to service as Keynes claimed. As a proportion of national product, the annual transfer was

3 Schuker, "American 'Reparations'."


not without precedent.40 Moreover, foreign finance was available to smooth the payment so that the entire burden did not have to fall on current consumption. The real problem was that successive governments made so little effort to move towards fiscal and monetary stabilization.

The Russian Budget Constraint

Due to grotesque resource misallocation (fueled by the demands of per- ceived Cold War threats, though in fact inherent in central planning), "So- viet growth over 1960 to 1989 was the worst in the world after we control for investment and human capital.",41 In 1985 the USSR embarked on an "acceleration policy," consisting largely of massive capital infusions into the ageing machine-tool sector. The Soviet budget deficit rose as a result, from about 2 percent of GNP in 1985 to 9-10 percent in 1989.42 Initially, this was financed through loans from foreign investors and governments, reducing the need for large-scale monetary financing of the deficit but raising gross external debt from $20 billion in 1985 to $96.8 billion at the end of 1991 (Table 1). About half this borrowing came from Western commercial banks, which tended to keep their loans short-term and at high rates of interest.

In the autumn of 1991, as the Soviet Union crumbled and Boris Yeltsin's newly-formed Russian government unveiled radical economic reform plans, the G7 countries hurriedly sent deputy finance ministers to Moscow to se- cure official pledges that Yeltsin would honor Soviet debts. He agreed. While the cost of state subsidies to support administratively controlled prices (including the exchange rate) mounted, the decline in measured output continued, and payments from the republics to the center evaporated. By the end of 1991, Gosbank's reserves had been exhausted, gold reserves had been dissipated, and central state grain reserves were practically nonexistent. In December 1991 the Soviet Vneshekonombank, which was responsible for the country's external obligations, declared bankruptcy and defaulted on all its liabilities, including short-term trade debts.

hnmediately after this debacle, the new Russian government began imple- menting its economic reform program under the direct supervision of Prime Minister Gaidar. This prompted the leading Western governments to promise substantial aid, to be released once Russia had agreed on a program with the IMF. But that condition in practice meant several months delay; meanwhile the window of domestic-political opportunity was rapidly closing. In April 1992, after four months of radical reform, the government was hard pressed to survive a hostile backlash at the Congress of People's Deputies. These

40 White "Making the French Pay." 41 Easterly and Fischer, "Soviet Economic Decline," abstract. 42 Lin, "Monetary Model," p. 369.


TABLE 1 RUSSIA'S EXTERNAL GOVERNMENT DEBT, 1991-1998

(US$ billions)

1991 1992 1993 1994 1995 1996 1997 1998

Federal debt Former USSR debt

Official loans 62.2 69.2 68.1 69.9 62.6 61.9 56.9 59.5 Commercial loans 32.9 34.0 34.0 37.0 39.3 38.8 33.9 35.2 Bonds 1.7 1.7 1.6 1.7 1.1 0.1 0.1 0.0 Total 96.8 104.9 103.7 108.6 103 100.8 91.4 95.2

Russian Federation debt Multilateral loans 0.0 1.0 3.5 5.4 11.4 15.3 18.7 26.0 Official loans 0.0 1.8 5.5 5.9 6.0 7.9 7.6 9.7 Bonds 0.0 0.0 0.0 0.0 0.0 1.0 4.5 16.0 Total 0.0 2.8 9.0 11.3 17.4 24.2 32.1 51.9

Total federal debt 96.8 107.7 112.7 119.9 120.4 125.0 123.5 147.1 Subnational government debt 0.0 0.0 0.0 0.0 0.0 0.0 1.1 2.2 Total government debt 96.8 107.7 112.7 119.9 120.4 125.0 124.6 149.3

Source: OECD, Economic Surveys, table 6, p. 67.

worrying developments induced the West to specify its aid commitment (at $24 billion) in advance of that summer's G7 summit in Munich, to which Yeltsin was invited. However, nothing concrete resulted. Gaidar struggled on in an increasingly adverse political climate for a further seven months. In that period, none of the promised assistance-an IMF standby arrange- ment (SBA), a $6 billion exchange stabilization fund, an official debt rescheduling deal-materialized, with the exception of an interim IMF credit of $1 billion, disbursed in August 1992 solely to boost external reserves.43 During the Congress of December 1992, Gaidar was replaced by Viktor Chernomyrdin.

Playing a role analogous to that of Keynes in the Weimar drama, Jeffrey Sachs published numerous articles arguing that financial aid, had it been delivered in 1992 as promised, would have helped Russia to stabilize and achieve a successful overall "transition."44 Such aid would have allowed Russia to escape IMF demands for fiscal stringency, thereby permitting the transfer to the budget of social spending previously managed by enterprises themselves (with the help of directed credits from the Central Bank). But this opportunity, Sachs argued, had been squandered.

It is at least debatable whether large-scale foreign assistance, had it been forthcoming, would have had the desired effect. Two considerations underlie such doubts. First, the structural distortions that needed correcting were deeply rooted in decades of central planning. Little of the industrial base was commercially viable, and changing this required more than unprecedented support for the Russian budget by foreign taxpayers. It also meant the intro-

"4 See Granville, Success. " Sachs, "Russia's Struggle."


duction of the institutions, structures, practices, and ultimately the attitudes, of free economic relations. Secondly, at this early date the generally unre- constructed Soviet elite lacked policymaking skills and, more importantly, failed to accept the implications of the transition and its irreversibility.

All conjectures aside, the fact remains that Russia launched its reform efforts with a large financing gap resulting from the Soviet debt it had inherited-loans, it should be recalled, that the West had extended to the system of central planning from which Russia was now trying to extricate itself. In that sense, there is an approximate analogy between the reparations burden imposed on the Weimar Republic to cover the cost of a war the previous German regime was accused of starting, and the external debt burden the Russian government inherited from its Soviet predecessor. Refi- nancing was impossible, since access to international capital markets was blocked following the December 1991 default on foreign bank debt. With the capitalization of unpaid interest, Russia's external debt burden mounted rapidly (Table 1).

The severity of the burden was at least acknowledged in long-term rescheduling agreements concluded with the Paris and London clubs of official and commercial creditors, respectively. In April 1996 a comprehensive rescheduling was agreed to with Paris Club creditors, covering about $38 billion of debt; and in December 1997 a 25-year rescheduling agreement covering approximately $24 billion was reached with the London Club.45 However, the collapse of Russian GDP in dollar terms (from about $430 billion to less than $130 billion), as a result of the 1998 ruble devaluation, left Russia unable to make even these reduced payments. The ratio of foreign debt to GDP increased from 26 to 113 percent between December 1997 and December 1998-higher than the German reparations burden of 1921 .46

If the full $17.5 billion due in 1999 had been paid, this would have cost Russia about 80 percent of planned tax revenue, not much less than the Allies expected Germany to pay in 1921. Russia was therefore forced to apply to both creditor clubs for further debt relief.

In February 2000 the London Club finally granted a 36.5 percent reduction in Russia's private-sector debt of $31.8 billion. The remainder was rescheduled over 30 years, with no principal repayments due for seven years, during which period Russia was to pay interest at barely commercial rates. But the Paris Club was much more reluctant to forgive debt, especially as the commodity price slump that had contributed so heavily to Russia's 1998

"4 Russia has also joined the Paris Club as a creditor country. This may help her to recover at least a fraction of her massive claims (about $130 billion) on developing countries (India, Iraq, Libya, Vietnam, Yemen, Cuba, and many others).

46 OECD, Economic Surveys, p. 66: Part of this increase is also explained by a buildup of $23.6 billion in debt during 1998. This consisted of commercial borrowing, Eurobond issues, and payment arrears on the former Soviet debt.


financial crash had been fully reversed by 2000, considerably boosting debt- service capacity.

Yet the underlying causes of the 1998 debacle, as for the wider failures of Russia's transition, are to be found not in the actions or inaction of the Western powers, but inside Russia itself. These domestic failures too were similar to the ones observed in Weimar Germany.

It was not only external debt service that caused Russian budget deficits. Total debt at the end of 1997 was about 55 percent of GDP, of which only around half was foreign debt. Domestic debt amounted to 28.4 percent of GDP, around 14 percent of which was in the form of short-term treasury bills (GKOs) and longer-term paper (OFZs).47 The failure to tackle the domestic component of the budget deficit can largely be explained by the levels of tax arrears, tax exemptions (about 7 percent of GDP), and tax evasion-in other words, by the shrinking of the revenue base.48 Successive governments failed to generate the political consensus necessary to reform a system largely inherited from the Soviet era, when the tax burden fell mainly on large state enterprises.

As in the Weimar case, tax arrears are easily explained by the Tanzi- Olivera effect: high inflation during the period 1992-1994 allowed taxpayers to exploit time lags between the calculation and payment of tax liabilities, which in turn reduced real tax revenues, hence increasing monetary financing requirements (given the lack of alternatives). Moreover, as Albert Fishlow and Jorge Friedman have shown, inflation and recession both en- courage tax evasion; together, they go far to explain why the Russian budget was consistently above 5 percent of GDP during the 1990s (Table 2).

THE LIMITS OF DEFICIT FINANCING

The immediate cause of hyperinflation in Germany and high inflation in Russia was the financing requirement of these large budget deficits. Of particular importance was the way the two central banks acted.

Hyperinflation in Weimar

On 31 July 1914, having lost gold in the amount of 103 million marks in the space of a week, the Reichsbank illegally suspended gold converti-

47 Domestic indebtedness of the Russian government consists of state treasury bills (GKOs), Federal Loan Bonds (OFZs), ruble-denominated savings bonds (OGSZs), restructured domestic foreign-currency debt of the USSR (OVVZs, known as Taiga bonds or MinFins), and securitized arrears on centralized credits to the agricultural sector and the Northern regions.

48 According to Grafe and Richter ("Taxation"), "Non-payment of taxes to the consolidated budget grew from around 3.4 percent of monthly GDP in January 1993 to some 80 percent of monthly GDP by mid-1997"; see also EBRD, Transition Report 1997, p.121.


TABLE 2 RUSSIAN FEDERAL BUDGET, 1993-2000

(percentage of GDP)

Actual Budget Law

1993 1994 1995 1996 1997 1998 1999 1999 2000

Overall balance -15.6 -10.6 -5.4 -7.9 -6.8 -4.9 -1.7 -2.6 -1.1 Primary balance -13.8 -8.8 -2.4 -2.2 -2.8 -1.1 1.9 1.6 3.2

Revenue 12.9 11.9 13.0 11.8 12.6 10.1 13.3 11.8 14.9 of which cash 9.2 10.0 9.0 11.6

Expenditure -28.5 -22.5 -18.6 -19.9 -20.0 -15.1 -15.0 -14.4 -16.0 Debt service -1.8 -1.8 -3.1 -5.9 -4.6 -3.9 -3.6 -4.2 -4.1

Domestic -3.7 -2.4 Of which GKO/OFZ 0.0 -0.2 -1.5 -4.0 -3.5 -2.2

Foreign -0.9 -1.5 Noninterest -26.7 -20.7 -15.5 -14.0 -15.4 -11.2 -11.4 -10.2 -11.9

Real GDP growth (percentage) -8.7 -12.6 -4.0 -3.4 0.9 -4.9 3.2

Source: IMF.

bility. This action was retroactively legalized four days later. New rules were introduced which allowed the Reichsbank to monetize not only government bonds and treasury bills, but also new State Loan Bank notes issued by wartime credit institutions. Under these arrangements the narrow money supply (currency in circulation or MO) increased sevenfold by November 1918.

Already by the middle of the war the government was encountering diffi- culty in funding its deficit through bond sales to the public; by the time of the last War Loan in 1918, only around a fifth of the floating debt (mostly treasury bills) could be funded.49 In the postwar period nearly all new borrowing was financed by issuing treasury bills, which the Reichsbank dis- counted at negative real interest rates. From July 1917 until October 1921, between a third and a half of the nominal value of treasury bills was held by the Reichsbank.50

Significantly, the wartime President of the Reichsbank, Rudolf Havenstein, remained in office throughout the period of inflation. Havenstein consistently feared a postwar "credit shortage." Only in July 1922 was the Reichsbank's discount rate increased-for the first time since the outbreak of war-from 5 percent to 10 percent, in fortnightly steps beginning on 28 July. This was too little, too late to be effective, as were subsequent increases in January 1923 (to 12 percent) and April of the same year (to 18 percent). When the number of bankruptcies had risen in the first half of 1921, the Economics Ministry had drawn up a plan to create a state "Eco-

49 Holtfrerich, Inflation, p. 117. 0 Ibid., pp. 67f.


nomic Bank" which would direct and allocate credit to "firms of essential importance to the national economy.""1 But this proved unnecessary as the Reichsbank itself, despite being made formally independent of the government in May 1922, continued to provide credits to heavy industry, open- handedly discounting commercial bills.52 After December 1922 public-sector borrowing once again swelled the monetary base as a result of the Ruhr conflict. This time, however, a rising proportion of treasury bills remained in the hands of the Reichsbank (from 68 percent in July 1922 to 93 percent a year later). The monthly rate of growth of MO spiraled upwards from 12.4 percent in July 1922 to 76.8 percent in February 1923, having never previously risen above 20 percent and only rarely having exceeded 10 percent.

Having been repressed by price controls during the war, inflation became more severe from the middle of 1919 onwards. Between the armistice and March 1920 the wholesale price index (WPI) rose sevenfold. Between mid- 1921 and mid- 1922, the WPI rose by a factor of roughly five. Thereafter, hyperinflation-defined by Philip Cagan as upwards of 50 percent inflation per month-set in (Figure 4). The complete collapse of the currency could now no longer be averted.53

The exchange rate sometimes led and sometimes lagged domestic inflation. In part this reflected the inconsistent enforcement of exchange controls, which were never sufficient to check domestic purchases of dollars as a hedge against depreciation. It also reflected divergences in foreign and domestic expectations.54 Up until mid-1922, for example, domestic investors seem to have been more gloomy than foreign investors about the chances of an eventual currency stabilization. The decisive influence on expectations seems to have been political news that implied a reduced likelihood of fiscal stabilization.55 In June 1922, in particular, the failure of proposals for a international loan to Germany and Rathenau's assassination seem to have dealt the fatal blows to foreign confidence."6

It was only in late 1923, by which time the paper mark was effectively worthless, that effective stabilization policies were put in place. However, even after Havenstein's death in November 1923, stabilization was less easily achieved than is usually realized. Contemporaries tended to look back on the introduction of a new currency (the Rentenmark) in November 1923 as marking the end of the inflation. This is not quite true. The collapse of the

51 Ferguson, Paper, pp. 289f; see also Feldman, "Political Economy." 52Feldman, Iron and Steel, pp. 131, 315f.; and Webb, Hyperinflation, pp. 123f. 53 Inflation as rampant as Weimar's is difficult to measure, and different indices can legitimately be

used, such as wholesale prices, consumer prices, or exchange rates. Whichever is adopted, it is clear that Germany experienced unprecedented inflation after the First World War, culminating in hyperinflation from mid-1922. See Cagan, "Monetary Dynamics."

54H oltfrerich, Inflation, pp. 75-78. 55 Webb, "Fiscal News." 56 Webb, Hyperinflation, p. 57.


300

280 WPI, Monthly Percent Change - - - Reichsbank Discount Rate

260 -

240 -

220 - Reichsbank Ruhr

200 London Granted Rathenau Occupation

180 - Ultimatum Independence Assassinated Begins

4 01 160 - 60 140-

120-

100

80-

60-

40

-20 Jan. July Jan. July Jan. July Jan. July Jan. July 1919 1919 1920 1920 1921 1921 1922 1922 1923 1923

FIGURE 4 GERMANY: INFLATION AND REICHSBANK DISCOUNT RATE, 1919-1923

(percentage)

Source: Holtfrerich, German Inflation, pp. 17, 52ff.

Reichsmark certainly made a currency reform necessary, but a new currency might well have gone the way of its predecessor had there not been a decisive "regime change." This took the form, first, of a temporary end to parliamentary government (after a period of political chaos): the key reforms were enacted under emergency Enabling Acts (passed on 13 October and 12 December). Secondly, Hjalmar Schacht, first Currency Commissioner and then President of the Reichsbank, pegged the Reichsmark at 4.2 trillion to the dollar and established a new Golddiskontbank with the aim of putting a new Reichsmark on the gold standard. (The Rentenmark was important for domestic payments at this juncture, but had no international function.) The budget was balanced by a series of Emergency Tax Decrees passed by the new Finance Minister Hans Luther (7 and 19 December), by the decree of 27 October which cut the number of Reich employees by 25 percent, and by the decree of 14 February 1924 which "revalued" various paper-mark assets. But only when Schacht imposed a strict credit freeze on 7 April 1924, de- feating renewed speculation against the currency, were the old inflationary tendencies finally stamped out. In the succeeding four months, the money supply stabilized, short-term interest rates rose to 45 percent, and prices fell


by 7 percent. Finally, a new international agreement, the Dawes plan, rescheduled Germany's reparations and arranged an international loan of 800 million gold marks.57

High Inflation in Russia

Russia's experience to date has not been so extreme. The initial price jump following decontrol was very large due to the monetary overhang and inflationary expectations: in January 1992 producer prices rose by 382 percent, consumer prices by 296 percent.58 But the subsequent high monthly inflation rates were due to fiscal and quasi-fiscal expenditures and the way they were financed.

Three periods are distinguished in Table 3 and Figure 5. The first, January 1992 to July 1995, saw large budget deficits financed by money creation, with the head of the Central Bank of Russia (CBR), Viktor Gerashchenko, playing an accommodating role similar to that of Havenstein at the Reichs- bank. The average real interest rate was negative, reflecting high and volatile levels of inflation and the lack of investment alternatives. Investors faced the choice between holding their liquidity in cash and bearing the full brunt of inflation, or investing it in foreign exchange or in ruble-denominated government debt. Inadequate foreign-exchange reserves (less than a month of imports) made the provision of the $6 billion stabilization fund an essential condition for an exchange-rate-based stabilization program to be put in place. In the absence of this, a flexible exchange-rate regime was retained until July 1995.

At first the CBR had only direct monetary instruments at its disposal: directed credits and mandatory reserves. The market for treasury bills did not come into existence until May 1993; demand was at first very thin, both because of high inflation (and the resulting capital flight) and because for- eigners were denied access. Central-bank credit auctions, designed to provide short-term liquidity to the banking system on market terms, began in February 1994. But despite its shortcomings, the money-based stabilization program forced the authorities to reduce the budget deficit. Failure would bring almost immediate inflation (the lag between money growth and an increase in the price level being about 3 months),59 and it quickly became clear that both voters and the nascent financial markets were averse to this prospect. "Black Tuesday" (11 October 1994), for instance, saw a 27 percent fall of the ruble exchange rate against the U.S. dollar as a result of an exces-

57 Ferguson, Paper, pp. 393-407. 58 This latter is the "urban price change"; the so-called hybrid CPI rose 245 percent. See Koen and

Phillips, "Price Liberalization"; Koen, "Measuring the Transition"; and Granville and Shapiro, "Rus- sian Inflation Statistics."

" Granville, Success.


TABLE 3 RUSSIAN INFLATION, 1992-2000: SUMMARY STATISTICS

(annual percentage change in CPI)

Jan. 1992 -July 1995 Aug. 1995 -July 1998 Aug. 1998 -April 2000

Mean 21.6 1.6 4.8 Median 15.2 4.7 2.4 Maximum 296.0 4.7 38.4 Minimum 4.6 -0.3 0.7 Standard deviation 43.5 1.5 8.2

Source: Goskomstat.

sive increase in M2 to finance the budget deficit. The event sparked a political crisis and government reshuffle, leading to a renewed commitment by Chemomyrdin and his ministers to a pro-stabilization strategy, and to Gera- shchenko's dismissal from the CBR. An SBA credit backing an IMF stabilization program was signed on 26 March 1995, and in April the CBR became formally independent, creating an institutional separation of monetary and fiscal policy.

In the second period, August 1995 to July 1998, prices were stabilized by replacing monetization with borrowing. Public debt grew even as the economy shrank: by 1997 treasury bill (GKO/OFZ) financing amounted to 4.6 percent of GDP, compared with 3.1 percent in 1995, and 71 percent of public-sector borrowing compared with 58 percent two years before. By the end of that year treasury bills accounted for half of total Russian domestic public debt.60

Unlike in the 1992-1995 period, the real interest rate was now consistently positive, and indeed high. Nominal interest rates varied between 1.4 percent and 8.8 percent per month, while inflation varied between -0.3 percent and 4.7 percent per month. The floating exchange rate was replaced with a crawling-peg regime in July 1995.

The rapid buildup of the GKO/OFZ market in 1995-1997 coincided with record capital flows into emerging markets. The main actors in this market were foreign investors (restrictions on nonresident participation were gradu- ally lifted between August 1996 and January 1998), the CBR, and the state- controlled Savings Bank (Sberbank) acting for the Ministry of Finance, which together accounted for about 60 percent of the market. Given the inadequacy of domestic deposits in the banking system, the budget deficit had to be funded to a significant extent by foreign purchases of treasury bills. By the time of the outbreak of the Asian crisis in October 1997, foreign investors accounted for about 30 percent of a market whose face value had grown to over $60 billion (from about $40 billion in October 1996 and $12

60 Goskomstat, Kratkosrochnye ekonomicheskie, various issues.


40 -Monthly Inflation Rate - - - GKO Yield

35 First Chechnya Collapse of War Interbank Domestic Monetization

30 Gaidar Black IMF Market Default and of Deficit

Reappoiated Tuesday approves Presidential Devaluation Resumes

25 -Sj A

Elec1ion

20 -

15

10

May May May May May May May April 1993 1994 1995 1996 1997 1998 1999 2000

FIGURE 5

RUSSIA: INFLATION AND YIELD ON SHORT-TERM PUBLIC DEBT, 1993-2000 (percentage)

Source: Goskomstat.

billion in 1995). That share remained broadly stable during the subsequent decline of the market, which culminated in the August 1998 default. The vulnerability entailed by this dependence was aggravated by the fact that more than half the domestic debt was very short-term. By the time of its collapse in 1998, the domestic treasury-bill market-with a face value of 14 percent of GDP-had an average duration of only 280 days. Short-term debt at the end of June 1998 was nearly four times as large as official foreign- exchange reserves.

Foreign risk-hunger was replaced by risk-aversion after the Asian crisis. As Asian banks suffered losses on lending at home, they sold their holdings of Russian high-yield bonds to improve their liquidity positions, putting pressure on the ruble and on the bond market. The monetary authorities sought to defend the ruble by raising the refinance rate, first in mid-Novem- ber 1997 from 21 percent to 28 percent, then in February 1998 to 42 percent, and in May 1998 to 150 percent. This rate acted as an effective cap on the treasury-bill yield and so signaled the level at which the CBR would support its price. The calculation was that inflows would be attracted by the high nominal yields on ruble-denominated debt and the promise of a stable ex-


change rate. Investors, however, were less attracted by this prospect than they were deterred by the present reality of ever-higher interest rates in the face of low-to-zero growth prospects, which created doubts that the government could afford debt-service costs reaching 40 percent of federal expenditures in May 1998.

In this environment all demand, domestic and foreign, for new issues of ruble-denominated treasury bills disappeared. The government could no longer pay debt with debt. Every week some 9 billion rubles ($1 billion) of debt matured, and these now had to be financed out of general revenues. The problem was exacerbated by a fall in oil prices and a rise in imports, which together led to the first current-account deficit since 1993, while putting further pressure on fiscal revenues. The IMF-led rescue package agreed on in mid-July 1998, though worth some $22.6 billion, failed to reassure investors and thereby to bring interest rates low enough to achieve a major expenditure reduction. Given the impossibility of sufficiently drastic cuts in noninterest expenditure, on 17 August 1998 the government announced its decision to default on its domestic debt and devalue the ruble.

In the third period, covering August 1998 to the present (April 2000), the current account strengthened rapidly thanks to the recovery of export- commodity prices and the devaluation, reaching a surplus of 20 billion rubles in 1999. Real GDP growth was 3.2 percent. The fiscal situation was consolidated, with the primary budget reaching a surplus of 1.9 percent of GDP, compared with the 1.6 percent targeted in the Budget Law (Table 2).- This, of course, altogether obviated the moral hazard of monetary financing. The crisis of the domestic banking system following the devaluation, which had left many banks with foreign obligations many times greater than their capital, had led to calls for public bailouts and thereby opened another temptation for monetary expansion. This temptation too was re- sisted, however. In 1999 annual inflation fell to 36.5 percent, compared with 84 percent in 1998. The forced restructuring of the government's domestic debt meant that its estimated ratio to GDP fell from 28 percent at the end of 1998 to 18.4 percent by mid-1999.61

Nevertheless, it is too early to conclude that Russia has avoided the hyperinflation trap into which Weimar Germany fell. The real domestic debt burden was falling in Germany too by 1922; but the external debt burden represented by reparations and private-sector borrowing remained a powerful source of instability. In the Russian case, the continuing growth of the external debt burden, and the excessive proportion of the budget required for its service, still pose a grave threat. The federal government's external debt was around 93 of GDP percent in 1999, compared with 32.6 percent just three years before. More than 36 percent of cash revenue was spent on debt service in 1999.

61 OECD, Economic Surveys, p. 65.


CONCLUSION

This article has compared the causes and effects of high inflation in Wei- mar Germany and the Russian Federation in the 1 990s. The model used by Sargent and Velde for post- 1789 France has been shown to have relevance for both the German and the Russian experiences. The principal sources of inflationary pressure were the government budget constraint and the monetary expansion that flowed from it.

The parallel is of course inexact: Russia has not yet experienced hyperinflation on the scale of Weimar Germany. In part this reflects the way monetary policy has been tightened since the 1998 default. But Russia has not yet succeeded in stabilizing fiscal and monetary policy as Germany did in 1924. Of course, Russia did not have to pay reparations to the victors of the Cold War, and this might be held to invalidate the comparison. But Russia did inherit a large external debt from the Soviet regime, and has since added to that burden considerably. In contemporary Russia, as in Weimar Germany, a large external debt has undoubtedly made internal adjustment harder, despite large inflows of foreign capital. Negotiations with the creditor clubs over Russia's external debt have come to occupy the same position occupied in the 1920s by haggling over reparations.

Inflationary policies had similarly distorting effects on the real economy. In Weimar Germany, subsidies to traditional sectors were used to conceal unemployment. But negative real interest rates stimulated investment less than was once thought, while there is some evidence linking the subsequent problems of the German capital and labor markets to the distortionary effects of the inflation.62 In Russia too, workers were anxious to stay in the formal sector, working short hours at low (or no) wages in order to retain their official connection to their enterprises and the accompanying benefits. But their real activity shifted to the shadow economy, progressively shrinking the tax base. In both cases, the excessive power of heavy-industrial lobbies was a significant factor in generating fiscal deficits.

Inflationary policies also had damaging social effects. By the time of the monetary reform and the stabilization in early 1924, large sections of the German middle class had seen their savings and pensions wiped out, and the real differential between their salaries and workers' wages dramatically reduced.63 Of course, the social structure of post-Soviet Russia has little in common with that of post-Wilhelmine Germany. Nevertheless, there are some parallels here as well. In Russia, the principal losers in the high inflation of 1990-1994 (repressed until 1992) were those with large sums in savings accounts, those dependent on pensions, and those on professional

62 See in general Balderston, German Economic Crisis. 63 Van Riel and Schram, "Weimar Economic Decline," p. 77.


salaries. This nascent middle class suffered a further severe blow to their position after the crash of August 1998.64 At the same time, public resent- ment has increasingly focused on the "oligarchs" who have been the most conspicuous beneficiaries of the Yeltsin regime.

In both Weimar Germany and Russia, inflationary policies were not only economically costly, but also politically dangerous. By discrediting free markets, the rule of law, parliamentary institutions, and international economic openness, the Weimar inflation proved the perfect seedbed for national(ist) socialism. In Russia, too, the immediate social costs of high inflation may have grave political consequences in the medium term. As in Wei- mar Germany, the losers may yet become the natural constituency for a political backlash against both foreign creditors and domestic profiteers. The words of Stefan Zweig are worth recalling: "Nothing ever embittered the German people so much ... nothing made them so furious with hate and so ripe for Hitler as the inflation."65

64 According to Goskomstat (Sotsial'no-ekonomicheskoe polozhenoe, yanvar-iul', 1999 goda, Rossiikoe statisticheskoe agenstvo, p. 210), the official government estimate/count of Russians living below the poverty line has risen from was 32.9 million or 22.4 percent of the population, in the six months up to June 1998 to 51.7 million, or 35.3 percent of the population, in the 1999 comparable period, an increase of 57.1 percent.

65 Quoted in Feldman, Great Disorder, p. 858.

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