Was Schacht Right? Foreign Debt, the Young Plan, and the Great Depression in Germany

Albrecht Ritschl, Universitat Pompeu Fabra (Barcelona/Spain) and CEPR

(a) Introduction
The German business cycle of the inter-war period is more volatile than that of other major European countries. The particular characteristics of Germany's performance have been the subject of extended debate. Under the impact of Keynes' (1920) polemic against the Treaty of Versailles, contemporaries automatically interpreted the violent German cycle in the light of the reparation problem. German postwar debates, however, have centered almost exclusively on fiscal mismanagement of domestic demand. Indeed, calculation of Full Employment Budget Surpluses exhibits a marked procyclical pattern of public budgets. Critics of the Keynesian position have pointed out that budget restraint during the Great Depression was the result of credit constraints rather than deliberate policy (Borchardt, 1991). Analysis of the term structure of German public borrowing as well as evidence from political history suggests that during the slump, funding problems did indeed exist. Borchardt had seen the reason for low creditworthiness in mounting economic instability during the years preceding the depression, notably in excessive wage increases. An index of deflated unit labor cost, which under Cobb-Douglas conditions should fluctuate around 100, indeed increases during the late 1920s. Comparison with Great Britain, however, reveals increases of real unit labor cost there as well (Broadberry/Ritschl, 1995), which casts doubt on the coerciveness of the labor cost argument alone.
This paper attempts to reconcile the various pieces of evidence by taking a fresh look at the German foreign debt and reparation problem. Accounting for the balance of payment restriction in a sovereign debt framework, I find an explanation for the public borrowing constraint during the depression. In this approach, there is also a role for the steep wage increases of the mid-1920s in setting the stage for the German depression. Borrowing abroad at high rates during the mid-1920s, the German economy afforded higher wages than would have been compatible with non-inflationary steady-state growth and balance-of-payment equilibrium. In 1929, Germany's trade deficits disappear, and during the depression, high surpluses emerge. To explain these swings and their interactions with domestic aggregates, I employ a sovereign debt framework that pays special attention to the participation constraints in the international credit market and their interaction with the various reparation settlements. It is argued that the incentive problems introduced by the sovereign debt character, i.e. the limited enforcability of German reparations help explain the German balance of payment and national income dynamics of the mid-1920s and during the Great Depression. I identify their driving force as the conflict between political and commercial creditors of Germany about the seniority of reparations over commercial debt. This squares well with results of Temin (1971) who had argued that the end of the German business cycle of the 1920s must have had domestic causes which were independent from the New York stock market crash. Following the consensus of contemporaries and policy makers at the time, I attribute the wave of capital imports after the hyperinflation to the effects of transfer protection under the Dawes Plan of 1924. Transfer protection implied that reparations collected in Germany would only be transferred into foreign exchange if enough reserves were available at the Reichsbank to avoid a run. This gave debt service on commercial credits de facto seniority over reparations. I will argue that with regard to expected future reparations, this "inverted" seniority clause made it rational for Germany to take in as much foreign credit as possible.
The central interest of this paper is in the regime change introduced by the advent of the Young Plan of 1929 which abandoned transfer protection. Announcement of this plan in March, 1929, triggered off a major crisis in Germany. The immediate consequence were a run on the Reichsbank, the failed issue of a major public loan, failure of an international bank credit and, consequently, a funding crisis of the public budget. On the political scene, the year between announcement and ratification of the Young Plan was characterized by infighting between the president of the Reichsbank, Schacht, and the government over whether or not to accept the Young Plan. In the course of this battle occurred the resignations, in turn, of the finance minister (Hilferding) and his under-secretary (Popitz), of Schacht as the president of the Reichsbank, and of the central government (Mueller), which after the ratification of the Young Plan was replaced by an emergency cabinet governing under presidential emergency decree. Schacht had predicted that given its high reparation demands, abandonment of transfer protection, and its very vague sanction clauses, accepting the Young Plan would throw Germany into a deep depression and political chaos. The paper argues that, irrespective of Schacht's "Nietzschean personality" (James, 1986) and his later political conduct as the Reichsbank's president of Nazi Germany, his economic verdict of the Young Plan cannot be discarded.

(b) Background: The Reparation Regimes
(i) The Dawes Plan Regime
The Allied reparations bill of 1921 amounted to 132 bn gold marks in present value, equivalent to over 200% of German pre-war national income. Attempts to enforce payment at the envisaged rates through sanctions failed in 1922, resulting in political chaos and hyperinflation. As an ultimate sanction, the military occupation of the Ruhr district in early 1923 was intended to produce more satisfactory reparation revenues. German obstruction disappointed these expectations but increased the social cost to the German side and led to another acceleration of hyperinflation. Given these conditions, the massive inflow of foreign capital into Germany after the stabilization of the mark of late 1923 is paradoxical. With reparations already more than exhausting Germany's willingness to pay, or the amount whose payment could credibly be enforced, it should be expected that Germany was effectively barred from foreign credit as long as reparations were in force.
To provide Germany with fresh money and circumvent this constraint, the Dawes Plan for German reparations of 1924 combined rescheduled reparation payments with a transfer protection clause. Under this scheme, reparations would only be converted into foreign exchange if sufficient reserves were available to avoid a run on the Reichsbank. Therefore, transfer protection implied that in the event of foreign exchange shortage, commercial credits would be served first, thus leaving reparations only as a second charge. This opened an incentive for Germany to take in commercial credit. Exhausting the credit ceiling by debt service on commercial loans, little room would be left for reparations. Although debt-plus-reparation service per period would be the same in the end, borrowing during an initial period would induce a one-time real resource transfer to Germany. These mechanics are well understood in the political history literature on German reparations (Link, 1970, McNeil, 1986), where it is pointed out that German policy makers at the time were fully aware of this effect and tried to exploit it to their advantage.
Under the Dawes Plan regime of 1924 to 1928, Germany indeed borrowed the equivalent of 25% of her national income of 1929 abroad, largely from the U.S., thereby far outweighing reparation payments during the same period. This has been termed "American Reparations to Germany" (Schuker, 1988). This credit gamble was supported by tax privileges for foreign credits; it met with stiff but unsuccessful resistance on the part of the Reichsbank under the presidency of Schacht who attempted in vain to impose measures enforcing budgetary discipline. Repeated warnings of Schacht and of the reparations agent installed by the Dawes Plan, Parker Gilbert, created increasing nervousness about the safety of investments in Germany and provoked discussion about future credibility of the transfer protection clause. Following the lead of J. P. Morgan ("the Germans are a second-rate people", James, 1985), New York banks lowered the credit rating of Germany since late 1927. Lacking the benefits from further transfer protection, the German government accepted renegotiation of the Dawes Plan in mid-1928, hoping to be able to trade in transfer protection for lower reparation payments. Under the Dawes Plan, reparations annuities had started from low amounts and grew into sizable amounts since 1927, bound to reach a steady state of 2.5 bn RM per year in 1929. To this would add some 1 bn RM of commercial debt service. The Germans hoped to attain a steady-state reparation annuity of some 1.4 bn RM, equivalent to that of 1927, to be paid unconditionally.

(ii) Transition to the Young Plan
Abandoning the transfer protection clause became the salient feature of the revised reparation scheme, announced as the Young Plan in early 1929. With reparations receiving full seniority over all other claims, the risk of future default or rescheduling now rested with commercial creditors. To the extent that the limit of repayment to which Germany could credibly commit herself was already exhausted, this would preclude further commercial lending to Germany, forcing the country into deflation to create surpluses on the primary trade balance. Contrary to German hopes, reparations were fixed at a level only slightly below the steady-state Dawes annuities. Stated in present value, the Young Plan amounted to some 35 bn RM, or about 50% of Germany's national income of 1929. To this added commercial debt of about 30 bn RM. German foreign debt on the eve of the Great Depression stood at almost 100% of GDP, which would indicate high country risk also by modern standards. Consequently, foreign lending to Germany came to a sudden halt. In mid-1929, attempts to replace the failed Hilferding loan of March, 1929, with credit by Dillon Read of New York failed largely because of French objections. As the Young Plan envisaged two last "mobilization" loans (the Young loan and, semi-officially, the so-called Kreuger loan), the French government expressed concerns that floating another loan might endanger the acceptance of the mobilization loans in international markets. As a consequence, government faced a mounting funding crisis that in late 1929 was averted by short-term central bank credit. This credit was consented by the Reichsbank, the reparations agent, and the French government only under the proviso that budget cuts be undertaken and a sinking fund for the amortization of Germany's floating debt be installed. German parliament succumbed to the pressure in late 1929, and as a consequence, the finance minister and his under-secretary, Hilferding and Popitz, resigned.
Confronted with the binding participation constraint, Germany was left with the choice between accepting or rejecting the Young Plan. The first option was adopted in March, 1930. Ratification of the Young Treaty was the last act passed under the Mueller cabinet before it resigned. Carrying out the austerity policies now considered as necessary was left to an emergency cabinet under Bruning which governed by presidential emergency degrees, thus shifting responsibility away from the political parties who would not dare advertise the coming austerity measures to their constituencies.
Rejecting the Young Plan was the option proposed by Schacht. Given the high annuities of the Young plan, Germany would have to deflate her economy relative to her neighbors under all possible contingencies, if she did not want to default on her commercial debts in order to pay out reparations. Given that during the negotiation process of late 1929, certain limitations to sanctions were eliminated from the original Young Plan and replaced by vague statements admitting vastly different interpretations, default on reparations themselves would be an impossibility without risking military intervention of the kind witnessed in 1923. Thus, the consequence of the Young Plan would be a severe depression that would culminate in a run on German credit and an international banking crisis. Schacht proposed instead to continue with the protected Dawes annuities, as in the event of an economic downturn the default risk would fall on reparations, not on international credit.

(c) Basic features of the model
In an imperfect world were binding state-contingent Arrow-Debreu contracts are absent, borrowers are prevented from defaulting only through the threat of sanctions and embargoes and, probably, through reputational forces. Reputation effects aside (whose weakness is documented with evidence from history, e.g., in Eichengreen/Portes, 1989), only welfare losses through sanctions etc. remain. Assuming common knowledge, this implies a credit ceiling in the first place. If this is reached, a binding participation constraint arises, and the debtor is banned from further credit. In a stochastic environment where a debt overhang may occur nevertheless, the question of whether or not a given portion of debt will be served depends, among other things, on its seniority position. "Junior" debts which enjoy least seniority will become worthless first. This eventuality, which banking practice often tries to avoid through risk pooling and consortium formation when a debt overhang is imminent (Bulow/Rogoff, 1989), has empirical relevance for inter-war Germany, where debt took both commercial and political forms and risk pooling between both was not feasible.
To model this, I consider a two-period world in which a domestic central planner maximizes the welfare of a representative, risk-averse consumer. The policy maker may import or export capital in the first period, while debt service and repayment of the principal are due in the second. Naturally, the central planner would like to import capital if in the first period, the rate of return on domestic capital is higher than the world market rate of interest and vice versa. If the policy maker cannot credibly commit to repaying the full amount in the second period, credit constraints may arise, and interest parity will not be fully achieved. Such a lack of credibility arises if it is possible for the country to retreat into the autarky position in the second period at a limited welfare loss, i.e., if there is an upper bound to the possible effects of sanctions etc. by the creditors' governments.
Reparations enter the model as an additional charge on the country's external balance. If reparations are first charge, they need to be paid up front in each period (by real resource transfer) before other external transactions are made. Then, commercial lenders in the first period account for this primary burden before making credit available. The country's credit limit is thus reduced by the present value of next period's reparation annuities. If reparations are high, little or no international credit will be available. In the extreme case where reparation demands are so high that they exceed the country's participation constraint, it is preferable for the reparation debtor to either default and suffer the welfare loss of sanctions or limit her payments to the amount that makes reparation creditors just abstain from imposing sanctions. The two latter cases roughly describe the economics of the German reparation problem between 1921 and 1923, which are not dealt with here.
What if reparations are not first charge? Then, two cases need to be distinguished. If reparations plus debt repayment in the second period are still below the country's participation constraint, the policy maker's incentives remain unaffected, and full service on both credits and reparation obligations will take place. However, if the sum of the two exceeds the constraint, the country will be in the default zone, and there is an incentive for the policy maker to attract as much foreign credit as possible. As long as it is known with certainty that in the second period, commercial debts will continue to enjoy seniority over reparations, their lending is perfectly safe up to the point where commercial credit alone exhausts the country's participation constraint. In that case, commercial lending drives out reparations completely. In the second period there will be partial default where commercial credit is fully serviced, while reparations are repudiated.
I argue that, pending some refinements to be discussed below, these are the conditions created by the Dawes Plan of 1924. Transfer protection created a mechanism which would always put reparation claimants at the end of the line waiting in front of the foreign exchange counter at the German central bank. As long as this scheme was safe, foreign creditors could act just as if the reparations agent was not present. For the Germans, high credit demand for economic reconstruction and high reparation annuities meant that the constraint would soon be reached. The incentive was to prefer repaying credits to paying out reparations, i.e, to take in credit at maximum rates.
There is an incentive problem also for reparation creditors. Once these understand the behavior of the reparation debtor, they want to renege on transfer protection. If in the model, the chance of reparations attaining first charge in the second period is the only source of risk, then under very general assumptions it can be shown that there is no default risk. To be able to default on reparations, the country would have to start borrowing at risk premia. As the reparation regime is the only source of risk, this would reveal the country's intention to default, which could be prevented by renouncing on transfer protection. However, if there are also other sources of risk like productivity shocks, the country may borrow at risk premia even if it does not intend to default on reparations. Then, partial default will only arise if in the second period, adverse productivity shocks occur. The incidence of default will then depend on the reparation regimes chosen by the reparation creditors.
However, in this case where reparation creditors may renege transfer protection, the credit limit for the debtor country in international markets is lower than in the case of continuing transfer protection. With it, a credit crunch in the domestic economy becomes more likely when transfer protection is abandoned: the country now bears part of the business-cycle risk herself, and due to the high amount of credit already outstanding she is extremely vulnerable to that risk. This is the essence of Schacht's criticism of the Young Plan.
Extending the model shows that once an adverse shock has occurred (as it did in 1930/1), no fresh money will be made available unless either reparations are abandoned or a positive shock occurs. In particular, standstill agreements or moratoria (like the Hoover moratorium on reparations of mid-1931) are insufficient to overcome the country's constraint and restore her international creditworthiness. This provides a rationale for the German attempts of 1930/32 to combine strict budgetary discipline and deflation with the goal of removing reparations, which was attained in mid 1932.