Chapter

Chapter 6: Germany in the Interbellum: Camouflaging Sovereign Debt

Author(s):
Thomas Sargent, George Hall, Martin Ellison, Andrew Scott, Harold James, Era Dabla-Norris, Mark De Broeck, Nicolas End, Marina Marinkov, and Vitor Gaspar
Published Date:
November 2019
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Mark De Broeck anD HarolD JaMes

It is a truth universally acknowledged, that a sovereign borrower in possession of an uncomfortably large stock of debt must be in want of camouflage.

Buchheit and Gulati (2014)

It is possible that no bank of issue in peace times has carried on such a daring credit policy as has the Reichsbank since the seizure of power by National Socialism. With the aid of this credit policy, however, Germany has created an armament second to none.

Hjalmar Schacht (1938)1

At the end of World War I (WWI), Germany faced a mountain of domestic debt, as well as substantial and uncertain external reparations. It chose to let hyperinflation wipe out the value of its domestic debt; arrangements to compensate bondholders lacked transparency and were bitterly contested. In the 1930s, a banking crisis amid worldwide economic turbulence triggered the materialization of significant contingent liabilities that were met through extrabudgetary means. The sovereign also sought recourse to “hidden” budgetary financing to fund a massive rearmament program in the run-up to World War II (WWII). On the external front, the country disputed its reparation obligations for most of the interwar period. In 1929, the Young Plan and associated external loan temporarily settled matters. But a partial moratorium on private debt service was introduced as part of exchange control measures in July 1933, and extended into a full moratorium on the transfer of foreign currency in 1934. Bilateral trade negotiations were then used to play out creditors against each other.

This chapter describes how the German government consistently avoided calls for clarity of its overall fiscal and debt position in an attempt to “violate” the intertemporal budget constraint.2 Supporting economy recovery in the wake of the worldwide depression and funding rearmament efforts required large-scale budgetary financing. But the government was concerned that voters and taxpayers would recoil from the implicit future liabilities. What started as an effort to conceal the true size of the sovereign’s obligations by “forgetting” to report part of the debt during the Weimar Republic developed into widespread deceptive budget practices under the Nazi regime.3 Creative efforts to introduce new borrowing mechanisms that would not stoke inflation or reveal the true scale of rearmament were put in place, drawing on the ideas of “financial wizard” Hjalmar Schacht, governor of the Reichsbank (the central bank).4 This was part of the Nazi regime’s broader efforts to manipulate public opinion through its strict control over economic information, newspapers, and other media.5 At the same time, the government misled foreign governments and foreign investors on its true intentions to service the country’s external loans.

Germany in the interwar period, both as a republic and, after 1933, a dictatorship, consistently sought camouflage, making a real accounting of the interaction between domestic and external debt and between sovereign debt, monetary policy, and the fiscal accounts challenging. This chapter describes the government’s efforts to conceal the extent of its financing needs and level of sovereign indebtedness during the interwar period.

Setting the Stage

The 1923 Hyperinflation and Stabilization: A Brief Reprise

WWI was pivotal in changing the size and maturity structure of the country’s sovereign debt. More than 50 billion marks of non-interest-bearing short-term Treasury bills were issued during the war.6 At the end of March 1914, sovereign debt amounted to less than 10 percent of GDP; more than 90 percent of it was in the form of long-term loans. By 1919, war-related debt represented more than 50 percent of GDP; almost 40 percent of it was short-term. Interest payments on the debt in financial year 1918 (April 1918–March 1919) absorbed almost 80 percent of regular tax receipts. Treasury bills held by the Reichsbank accounted for nearly two-thirds of the Reichsbank’s assets, assuming a value larger than that of its notes in circulation.

Efforts to put public finances in order and establish a well-functioning domestic market for long-term government debt proved fleeting in the aftermath of the war. As spending pressures built, the widening fiscal deficits were covered by ever-increasing amounts of short-term paper, setting the stage for the 1923 hyper-inflation.7 With limited access to external and domestic long-term financing, issuance of short-term Treasury bills ratcheted up. At the end of 1922, the Treasury bill stock approached 1,500 billion marks, an almost fivefold increase in six months. Secondary market prices of government bonds were no longer responsive to financial conditions (Figure 6.1).

Figure 6.1.German War Loan Prices and US Dollar Exchange Rate, 1920–23

(in Percentage of Face Value)

The January 1923 occupation of the Ruhr region by French and Belgium troops (see Chapter 2 on the UK and Chapter 4 on France) further eroded confidence in the currency. In the first half of 1923, the mark exchange rate collapsed. As tax collection evaporated, the issuance of Treasury bills accelerated, nominally covering an ever-increasing share of spending. Following unsuccessful attempts to stabilize the exchange rate, the Reichsbank depleted its gold and foreign exchange reserves by mid-1923. Using the mark/US dollar exchange rate as deflator, the Treasury bills stock at that time is estimated to have been worth less than one-third of its value at the beginning of the year in real terms, despite massive nominal issuance (Figure 6.2).

Figure 6.2.Value of German Domestic Reich Debt, 1923

(in Millions of Reichsmarks)

Source: Interwar Debt Database.

Note: RHS = right-hand side.

In mid-November 1923, the government issued a new currency, the Rentenmark, and established a new financial institution, the Rentenbank, to issue notes denominated in this currency.8 As a private financial institution, the Rentenbank could extend loans to the government and the private sector within strict quantitative ceilings. In parallel, the government adopted major economic reforms to stabilize the economy.9 Government spending was slashed, commercial lending standards were tightened, and Reichsbank independence was codified in legislation. In autumn 1924, a new currency, the Reichsmark (RM), was introduced with a 1-to-1 ratio with the Rentenmark (a 1-to-trillion ratio with the mark), and Rentenbank notes were gradually withdrawn from circulation.

In tandem with the reforms to create an independent central bank, treasury and debt management functions were strengthened and data and information on sovereign debt regularly published. A Reich Treasury was established as a separate agency. The debt agency from early 1924 operated as a collegiate body largely independent from the Treasury and under the oversight of a new Debt Council composed of members of Parliament.10 The Debt Council had the authority to approve borrowing in accordance with existing legislation. Daily bond price quotations, weekly Reichsbank statements with claims on the government, and monthly government debt statements were published. As an important source of external monitoring of government debt, the Agent General for Reparation Payments also presented detailed government debt data and discussed debt policies in its regular reports issued during 1925–30.11

Hyperinflation and the Issuance of Indexed Debt

In one of the first documented instances in history, the German sovereign issued domestic debt indexed to gold and the US dollar amid the economic crisis. Indexed debt offered holders protection against hyperinflation without creating future claims on the country’s gold and foreign exchange reserves. Three main issuances over this period added considerably to the sovereign’s debt servicing burden without clear long-term benefits. They represented the sunk costs of hyperinflation from the fiscal perspective:

  • In early 1923, the government borrowed $50 million for a three-year period as an external loan to help stabilize the exchange rate versus the US dollar. The proceeds of the loan were used for foreign exchange market intervention. However, the failure to contain budget deficits resulted in domestic liquidity creation. This fueled additional demand for foreign exchange, draining the country’s already scarce gold and foreign exchange reserves. The Reichsbank, which had taken over the servicing of the loan, eventually had to abandon efforts to stabilize the mark exchange rate.
  • In August 1923, a 500 million domestic gold mark loan with a 12-year maturity was issued. The loan was serviced in marks indexed to the value of the US dollar at the prewar gold parity (4.2 marks to the US dollar).12 Denominations as small as one-tenth of a US dollar were made available to facilitate circulation. Treasury bills with a real value protection thereby assumed the function of currency.
  • Approximately 400 million in domestic gold mark loans were issued in late 1923 to secure emergency currency from government bodies (Figure 6.3). The Reichsbank issued “Zwischensheine” that could circulate as currency. Treasury bills from then on served as credible backing for currency through an indexation mechanism. The private sector also issued a variety of emergency currencies backed by gold mark loans. These loans were again serviced in marks indexed to the value of the US dollar at the prewar gold parity.

Figure 6.3.Small-Denomination Treasury Bill Indexed to US Dollar, October 1923

Source: Spink.

The August 1923 indexed loan was meant to provide backing for a medium of exchange for the general population. Subscribers could use the loan certificates as a method of payment effectively linked to the US dollar. Small denominations of the certificates, which entitled the holder to a repayment premium at maturity, circulated directly as currency. Larger denominations of the certificates, which carried an annual interest coupon, served as collateral for inflation-protected emergency money issued by subnational governments and companies.13 The government used the loan proceeds to cover part of its deficit, but it assumed an additional cost to ensure that the loan certificates would be widely accepted as a method of payment.

Indexed loans supported the introduction of emergency currencies, but they could not halt the hyperinflation, the ensuing collapse of the mark exchange rate, and the flight from traditional currency. The emergency currencies were withdrawn in 1924 following monetary stabilization, but the government continued to service the indexed loans that backed them, incurring an additional sunk cost of hyperinflation.

An Early Response to Hyperinflation: Compensating Losers

With the introduction of the RM as the new currency, domestic currency debt was serviced following the “mark equals mark” legal principle. One RM could discharge one trillion marks of service on paper mark debt, essentially leaving holders with worthless RM claims. The administrative cost of servicing the paper mark sovereign debt in RM vastly exceeded the value of the actual payments, but early redemption options for RM-denominated debt were limited.

Mortgage holders, however, successfully challenged the “mark equals mark” principle in court. A November 1923 Supreme Court judgment endorsed revaluation of mark mortgage contracts, triggering political momentum to revalue other similar debt. A February 1924 government decree—a cabinet decision approved using emergency powers—organized revaluation for private contracts. The decree failed to settle the issue politically, and revaluation was a prominent theme in the 1924 parliamentary elections.

Yielding to pressures from various stakeholders, the government eventually reached a compromise on partial revaluation of public debt.14 There was limited budgetary room to service revalued sovereign debt, a new and unplanned spending item. At the same time, the government had to weigh the distributional and social considerations. The result was a convoluted arrangement, formalized in the July 1925 Loan Liquidation Act. At the end of 1925, approximately 73 billion of mark Reich debt, legally worth a little more than seven RM pfennig, qualified for conversion to approximately 1.8 billion RM loan liquidation debt.

  • The act swapped paper mark debt into new RM debt at a predetermined conversion rate. The new debt carried a coupon rate of 4½ percent per annum from January 1, 1926.
  • The conversion rate was set at 40-to-1 of the face value of mark debt, with higher conversion rates for debt issued during 1919–23. This was more generous than the 1 trillion–to–1 conversion rate implied by the “mark equals mark” principle.
  • The arrangement did not apply to most short-term Reich debt.

The law introduced preferential treatment for holders who had acquired mark debt before July 1, 1920, reflecting concerns about possible speculative activities during the hyperinflation.15 These holders could participate in annual amortization drawings of loan liquidation debt over a 30-year period. Drawn debt received a premium of four times its nominal value, as well as the 4½ percent coupon payments. Following completion of a complicated registration process, an approximately 1 billion RM loan liquidation debt was registered by “old holders.”

Motivated by distributional considerations, the law further introduced special categories of large and small pre-July 1920 holders. Large holders’ amortization rights were reduced to less than one-for-one for holdings above 12,500 RM. Very small holders, with holdings of less than 500 RM, could opt to receive a lump sum payment instead of drawing rights. The law offered individuals with an annual income below a poverty threshold of 1,000 RM the option to convert drawing rights into annuities, including an annuity bonus for those age 60 years and older at the time of conversion.

By the end of 1928, almost 4 million holdership declarations were received, including more than 100,000 from abroad (see also Chapter 1 on the US).16 Most declarations were from smaller holders, including almost 700,000 declarations below the 500 RM threshold for cash compensation. Many declared holders were not satisfied with the compensation offered and continued agitating for additional benefits, including through organized political opposition.

The revaluation controversies drove long-term government debt prices. Mark debt was quoted on the Berlin Stock Exchange even after the hyperinflation, with prices in the 1 to 2 percent of par range. Because this debt would have been worthless without revaluation prospects, prices clearly reflected investors’ expectations of partial compensation. Prices, however, dropped in the second quarter of 1925, when the compromise legislation was underway, suggesting that it was less generous than investors anticipated (Figure 6.4).

Figure 6.4.War Loan Prices, 1924–26

(in Percentage of Par Value)

Sources: Berliner Börse, Abteilung Wertpapierbörse (various issues).

German nationals whose property was lost or damaged during WWI also received compensation. The March 30, 1928, War Damage Liquidation Law again differentiated between claimants based on the size of the entitlement. Claimants with damages of less than 20,000 RM were paid in cash; individuals with larger damages received debt certificates denominated in RM but with the gold value guaranteed. The certificates were redeemable over a period of 20 years, with smaller holders scheduled to be redeemed first. The complexity of the arrangement once more reflected the difficult political economy trade-offs.

Challenges with Relaunching the Market for Long-Term Debt

In the initial post-stabilization years, reestablishing the market for new long-term sovereign debt was not a priority. With the Treasury cash position in surplus, there were no immediate market funding pressures. Moreover, investors had experienced how hyperinflation could wipe out the value of bonds without explicit inflation protection and continued to view nominal bonds as very risky. The complexity of the 1925 revaluation exercise further undermined confidence in the sovereign’s ability to service the nation’s long-term debt.

The first post-stabilization long-term domestic loan was issued in February 1927. The government wanted to take advantage of the prevailing favorable money market conditions and the reduction of the Reichsbank discount rate to 5 percent. Facing an untested market for new long-term debt, the government issued the loan significantly below par, at 92 percent, and with restricted initial tradability.17 With the lifting of tradability restrictions approaching in mid-1927 and the tightening of general financial market conditions, the market price of the bonds fell to less than 86 percent of the issuance price. Concerned that investors “who are under an obligation to draw up balance sheets have been obliged to show considerable losses on this account,”18 the new rate applied until July 1934, when the first drawings of bonds under the sinking fund were scheduled. Although the coupon adjustment helped ease pressures, it also created a bad precedent for the issuance of new long-term loans.19

An attempt was made to launch a new domestic long-term loan to individual investors in May 1929, using a range of tax incentives. Compared with the previous loan, the new loan targeted a smaller amount (300 million RM), carried a much higher coupon (7 versus 5 percent), and had a shorter maturity. Final subscriptions fell substantially short of the target. The loan was considered a failure, and the sale of interest-bearing Treasury certificates to financial institutions began to gather steam. The certificates had a maturity of up to one year and could be traded among financial institutions. Their issuance marked the beginning of a trend to direct placement with the financial sector instead of sales to the public. By the end of 1929, more than 10 years after the end of WWI and more than six years after the end of hyperinflation, Germany continued to face challenges in issuing new long-term domestic sovereign debt.

When the worldwide depression hit Germany in the first half of 1930, Parliament rejected the austerity measures proposed by the then Chancellor Brüning, leaving the government without the authority to borrow. In response, the Chancellor dissolved the Parliament and used the emergency provisions of Article 48 of the Weimar Constitution to govern by special decree. The first special decree, from July 26, 1930, authorized the Finance Minister to borrow up to 500 million RM on behalf of the Treasury.20 The Debt Council objected to the arrangement on the grounds that the Weimar Constitution gave Parliament the exclusive right to authorize sovereign borrowing. The government resorted to temporary decrees for fiscal financing, but no further efforts to place long-term debt were made.

The 1931 Banking Crisis

As the Great Depression intensified, the German banking and economic system was shaken by a severe crisis in the summer of 1931. Creditanstalt, Austria’s largest financial institution and the main regional bank for central Europe, failed on May 11, 1931, triggering a bank run and contagion to Germany. Germany now faced a simultaneous banking, currency, and fiscal crisis.

A critical part of the problem was government debt management. The central government faced rising deficits, largely driven by automatic social expenditure as a consequence of the gathering depression. The instability increased after the political shock of the high Nazi vote in the September 1930 parliamentary elections. The leading official in the Finance Ministry, State Secretary Hans Schäffer, noted: “If only a few big firms get unto difficulties or internal troubles lead to the calling of short-term credit, there is an acute danger that treasury bills cannot be accommodated. Especially from the viewpoint of foreign policy, such a situation is intolerable” (James 1985, 120).

In response, the government turned to the international market for a two-year $125 million bridging loan, in a syndicated credit of 22 American, 1 Canadian, 23 German, and 3 Swedish banks, coordinated by the Boston bank Lee Higginson and concluded on October 12, 1930. Diplomatic historian Edward Bennett concludes his account: “This was the last great foreign credit that the Weimar Republic was to receive, and those who lent the money soon regretted their action” (Bennett 1962, 20).

The loan agreement was predicated on implementing an ambitious domestic austerity program, increasing contributions to unemployment insurance, and reducing central government subsidies to state and local governments. It carried a peculiar escape clause: “If the financial or economic situation in Germany between the date of execution of this Agreement and the putting into effect of the legislation referred to in Article I thereof should be adversely affected in such a manner that the granting of the credit by banks may not reasonably be asked for, or if such legislation referred to in Article I is not enacted with the concurrence of the Reichstag, the Reich and the Bankers will reconsider whether and in what form the credit can be carried through.” In fact, the legislation was not passed through a parliamentary vote but through an emergency decree.

At the end of December 1930, the government arranged to issue more short-term government securities. Because longer-term funding schemes had not come to fruition, the government was dependent on selling short-term debt to the German banking system.21 After May 1931, as the German banking system lost deposits in a banking run, the banks could no longer absorb short-term government debt. In May 1931, German banks lost 2.6 percent of their deposits (337 million RM), and the bank run accelerated. On June 5, 1931, a new emergency decree imposed new fiscal austerity, cutting civil service pay and increasing the sales tax. The April and May fiscal yield was less than expected, and the government needed to sell an additional $125 million of Treasury bills. On June 20, the international moratorium on US debts declared by President Hoover (see Chapter 1) brought some temporary relief, but the problem returned; the schedule of central government payments, with a large sum due on July 15, provided what constituted a countdown to banking disaster.

The central bank extended an emergency line of credit on July 9 but—partly because of foreign pressure—ensured that it was not renewable beyond July 16. Relatively small government deficits were impossible to finance by a banking system under strain, and the prospect of the government not being able to pay increased the sense that the banks were vulnerable. This argument was at the heart of US consular reports; one from May 1931 stated: “The consistent uncertainty and insecurity with regard to the Reich’s finances during the past year seems to have been one of the main reasons for the severity of the economic depression” (quoted in James 1986, 305). This entailed a doom loop between banks and government debt.

The government faced an initial cost of banking sector support of around 914 million RM, around 1 percent of 1931 GDP.22 Of this amount, approximately 650 million RM were spent on three large commercial banks (Danatbank and Dresdner Bank, which were merged under the name of the Dresdner, and Commerzbank) and approximately 150 million RM on the agricultural credit cooperatives. In addition, the sovereign in 1931–32 issued 347.2 million RM special Treasury notes to support the balance sheet of banks,23 and in 1931, it injected 20 million RM in the Akzept und Garantiebank established under the umbrella of the Reichsbank.24 The Reichsbank used the affiliated Gold Discount Bank to recapitalize the merged Dresdner bank (91 percent stake), the Commerzbank (69 percent stake), and the Deutsche Bank (35 percent stake).25

The state eventually reprivatized the merged Dresdner Bank and the Commerzbank in 1936–37, generating around 250 million RM in cash for the Nazi regime. The reprivatization proceeds, however, fell far short of the total cost of state support to these banks, leaving the state with a net loss of approximately 615 million RM on account of them.26 When unrecovered support to the rest of the financial sector is added, by 1938, the government was facing a documented permanent loss of approximately 875 million RM from the 1931 crisis, less than 1 percent of German GDP that year.27 No data were published on possible calls on Reich guarantees granted to the two bad asset companies.

Financing Public Works and Rearmament: Camouflage Through New Financial Instruments

The 1932–35 New Domestic Financing Strategy

In the midst of collapsing domestic economic activity and accelerating unemployment, the authorities embarked on an ambitious fiscal expansion to support economic recovery. Because it was not feasible to finance the deficit through long-term domestic or external borrowing, new financial instruments were introduced. These provided tax relief without raising the cash deficit or relaxing legal limits on central bank financing.

The first category of one-off instruments, tax remission certificates, was introduced in September 1932. These certificates shared many of the characteristics of tradable government debt but did not involve cash payment of interest or principal. Taxpayers received certificates in proportion to payments on selected taxes during October 1932–September 1933 and for hiring new workers during that period. The certificates carried a 4 percent annual coupon and could be used for payment of federal taxes (other than corporate and income taxes) in the fiscal years 1934–35 to 1938–39 at an annual rate of 20 percent of the total value, including accumulated interest. The certificates could be sold freely on the stock exchange or to a consortium of banks, used as collateral against loans for up to 75 percent of their market value, and offered for rediscount at the Reichsbank. Secondary market prices at the Berlin Stock Exchange were close to discounted par values, suggesting that the 4 percent coupon rate was set in line with market conditions.28

Another category of one-off financing instruments, employment creation bills, was issued in early 1933 (Figure 6.5). These bills were the first example of complex financial engineering of its kind. They were designed to have the characteristics of regular commercial bills of exchange but could only be used to finance public works. The bills were drawn for three months and made renewable (up to 19 times) while carrying the same maturity as regular commercial bills to accommodate public works projects with a medium-term horizon. The government provided special guarantees in the form of tax remission certificates or employment creation debentures, paid the interest, and redeemed the bills. After endorsement by an ordering agency, contractors could present the bills to specialized, publicly owned financial institutions. The bills could then be (re)discounted by commercial banks or the Reichsbank. Through this mechanism, the bills gained the character of medium-term (up to five years) discountable paper.

Figure 6.5.Mechanism of Employment Creation Bills

Source: Teutul (1962, 72).

Although employment creation bills did not generate interest savings for the budget,29 they were a more attractive investment for commercial banks than regular medium-term Treasury certificates, which were not discountable and, hence, less liquid.30 In tandem, steps were taken to make alternative investments less attractive. For instance, new legislation on the distribution of profits by corporates capped cash dividends at 6 percent of the par value of the stock. Any excess cash dividend was to be paid to the Gold Discount Bank and invested in government bonds on behalf of the shareholders.

Despite these measures, market conditions did not support new sovereign bond sales. Secondary market prices at the Berlin Stock Exchange suggest that the government would have had to offer a coupon of at least 6 percent on new debt. The government instead opted for a comprehensive conversion operation to bring down all long-term interest rates to a maximum of 4½ percent.31 Recognizing that the 4½ percent coupon fell short of prevailing market conditions, the government placed the loan with the publicly owned Union of Savings Banks and the Clearing Bank Association. Formally, the loan conversion was voluntary. Investors could refuse to participate and continue to receive the original higher interest rate. However, they could no longer trade nonconverted securities on the stock exchange or have them accepted as collateral by the Reichsbank. Investors also faced considerable political and social pressures to convert. In the end, very few refused to do so.

The conversion marked the end of efforts to establish well-functioning primary and secondary markets for domestic long-term government debt. The government continued to fully service converted bonds and new domestic sovereign debt until the end of WWII. This was in line with policies to have Germany’s foreign currency debt serviced in domestic currency equivalent, a tactic that protected domestic holders of foreign currency debt (see later in this chapter).

Transitional Financing: More Creative Financial Engineering

In March 1935, the Nazi regime declared rearmament to be the country’s top priority. Existing programs to stimulate employment were folded into the armament program, with Hjalmar Schacht, the Reichsbank governor, at the helm of a new financing strategy. This had to cover the regime’s planned massive increase in military spending without creating inflationary pressures.32 A key component of Schacht’s strategy was to expand the use of Mefo bills, which had been introduced in the context of the employment creation program, for armament financing. Mefo bills were drawn by armament contractors and accepted by a limited liability company, the Metallurgische Forschungsgesellschaft, m.b.H. (MEFO), set up solely for financing purposes. The drawer could present Mefo bills to any qualifying German bank for discount. The banks, in turn, could rediscount the bills at the Reichsbank at any point within the last three months of their earliest maturity. The bills essentially added a shadow company to the financing scheme conceived for the public works program (Figure 6.6).

Figure 6.6.The Design of Mefo Bills

Source: Golla (2008, 181).

Mefo bills served as a key financing source for the armament program, covering more than one-third of German military spending during April 1935–March 1938.33 The stock of Mefo bills increased sixfold over this period, and by March 1938, the bills had grown into the largest component of total (reported and unreported) debt. Mefo bills, however, were not included in official debt statistics. Reporting on government spending and its components was already discontinued as early as 1935. Published financial sector balance sheets that could have identified holdings of these bills were also carefully sanitized.34

Mefo bills circulated widely outside the Reichsbank among companies and financial institutions. They carried a government guarantee, had an attractive 4 percent interest rate, and could be discounted (and rediscounted). The Reichsbank anticipated that until the economy had reached full employment, the pace of rediscounting the bills would be in line with the rebound in economic activity and hence would not be a source of excessive money creation.35 By early 1938, once the economy had reached full employment, issuance of Mefo bills was discontinued. Reliance on institutional savers to place medium- and long-term debt now gained importance (Figure 6.7).

Figure 6.7.Debt Composition: Use of New Instruments, 1931–1939

(in Percent)

Source: Interwar Debt Database.

Note: MLT = medium- and long-term.

To complement the existing range of short-term and long-term instruments, the government also introduced a new medium-term instrument. The new security was a 4½ redeemable Treasury note with a maturity of 10 years. The security was quoted on the stock exchange, and its liquidity was ensured by inclusion in the list of securities qualifying for Reichsbank open market operations. The rate of issuance of medium- and long-term loans progressively increased as loans were offered in larger sizes and floated at closer intervals.

The new financing instruments and mechanisms shifted the pattern of government borrowing. By the late 1930s, however, the sharp increase in overall government borrowing and the accumulation of Reichsbank claims on the state could no longer be concealed. Other sectors of the economy were increasingly crowded out (Figure 6.8).

Figure 6.8.Securities and Lending by Borrower, 1931–39

Sources: National sources; authors’ calculations.

Note: RHS = right-hand side.

Data Obfuscation and Fiscal Non-transparency under the Nazi Regime

The Nazi regime allowed for regular publication of the country’s debt data until well into WWII. But information available within the public domain was increasingly restricted. For instance, the Debt Council no longer issued public reports. The government also discontinued the publication of data on government spending or the fiscal deficit and its financing. In the absence of public information on debt management and fiscal policies, the Nazi regime could allow for the statistical release of Reich debt data in the Weimar format, suggesting an illusory transparency.36

The Nazi regime also went to great lengths to legitimize its financial practices. It left the fiscal and debt management legislation from the Weimar period largely in place, but budgetary powers were transferred from Parliament to the Cabinet.37 An amendment to the Weimar Constitution approved on March 23, 1933, gave the Cabinet legislative powers with respect to constitutional provisions regarding budgetary and sovereign loan authorizations.38 The Finance Ministry continued to prepare an annual budget proposal and budgetary accounts but no longer submitted them to Parliament. In February 1935, the ceiling on borrowing authorizations was removed. From this point, the government could borrow any amount authorized by the Chancellor upon request, but the public was left in the dark on the amount actually approved.

The inflationary effects of rapidly increasing government spending under the Nazi regime were also masked. From 1934, price controls were imposed. One consequence was covert inflation, in which prices remained fixed but the quality of goods deteriorated. This was especially true of textiles and shoes, but it also applied to some foodstuffs, where the use of substitute (ersatz) materials for expensive imported goods was a consequence of exchange control legislation.39

The regime issued exhortatory statements about fiscal restraint intended to reassure Germans who were worried about the possibilities of a new bout of inflation. In 1933, the periodical Währung und Wirtschaft explained that the government needed to avoid “any threat to the currency” by “resisting the endless demands made at all times on public funds” (James 1986, 379). Hitler boasted: “I had to also make it clear to Schacht that the first cause of our currency stability is the concentration camp: the currency is stable when anyone who demands more is dealt with” (Jochmann 1980, 88).

New Financing Strategy and War Financing

By early 1938, fearing the inflationary consequences of increasing military spending, Schacht presented a new financing strategy designed to eliminate the issuance of special bills, raise additional tax revenue, and place long-term loans. The Reichsbank issued new certificates in exchange for large blocks of maturing special bills. New Treasury delivery bills were introduced, which entailed exchanging short-term debt for liquid central bank liabilities. The bills could only be issued by the Treasury for six months and in amounts that could be fully repaid at maturity out of the proceeds of long-term loans.40

Schacht’s new financing strategy was not effective. The annexation of Austria and the military campaign against Czechoslovakia created substantial unplanned additional spending needs. The Treasury was forced to place more delivery bills than planned; in early 1939, it stopped issuing new ones. In September, formal independence of the Reichsbank was revoked by the Cabinet.

Direct placement with the financial sector increased, and issuance of non-interest-bearing debt surged. New short- and medium-term certificates that could be used to pay future taxes and customs were issued (Figure 6.9). These certificates served as both a forced loan and a transaction medium, but they did not circulate beyond suppliers and contractors.41 Tax credits and other incentives (for example, deductible depreciation allowance) were provided to induce holding. During April–October 1939, the government issued almost 5 billion RM in tax certificates, accounting for approximately 40 percent of its total net borrowing.

Figure 6.9.Short-Term Tax Credit Certificate, 1939 Series

Source: Spink.

In marked contrast to the large and well-publicized war loans sold to the public during WWI, the government opted for “silent financing” during WWII (see also Chapter 5 on Italy). The composition of debt shifted to medium- and long-term instruments placed with savings banks and insurance companies (Figure 6.10). High taxation of income, rationing of consumer goods, and control of private investment strictly limited household and corporate discretionary spending. As in Italy, households and corporates had no outlet other than savings products offered by the financial sector. Savings banks and insurance companies, in turn, systematically channeled all available financial resources to the government.

Figure 6.10.Debt Composition, 1939–1944

Source: Interwar Debt Database.

Note: MLT = medium- and long-term.

As war financing needs increased, financial repression escalated. Maturities of Treasury certificates were lengthened.42 Interest rates on medium- and long-term debt were reduced: Treasury certificates issued before 1941 paid 4 percent interest, and later issuances paid only 3½ percent. The interest rate on liquidity bonds was initially set at 4½ percent but eventually was reduced to 3½ percent. Reliance on central bank financing also ramped up. The last published Reichsbank balance sheet (from March 7, 1945) shows that the 70.2 billion RM of Treasury bills and certificates held by the Reichsbank had almost completely crowded out the asset side of its balance sheet. Upon surrendering in May 1945, the Reich ceased servicing the country’s domestic sovereign debt.

Germany’s External Debt Obligations: Permanent Renegotiation

Commercializing Reparation Obligations: The Dawes Loan

Following extensive intergovernmental and commercial negotiations under the auspices of the Dawes Plan, Germany tapped private international financing in 1924. The objective was to reduce and partially commercialize its reparation obligations. For the international community, turning part of Germany’s reparation obligations into loans sold to private investors was expected to move the problem from the political to the commercial sphere (see Chapter 1 on the US).

International bankers recommended giving the loan seniority over all other claims on Germany, including reparation payments, and issuing the bulk of it in New York and London through a joint Anglo-American effort.43 The bankers emphasized the need to ensure that Germany was fully committed to the Dawes Plan and had the capacity to service the loan: “Our markets will need to be assured not only that the loan is a first lien on Germany’s assets and revenues, but also that it is the obligation of a solvent Government and a solvent country.”44 The loan was eventually floated after the servicing of the Dawes loan was granted seniority over all reparation payments. Service of the Dawes loan was further protected by a first charge on German customs duties; taxes on tobacco, beer, and sugar; and the net revenues of the alcohol monopoly.

The Dawes loan was issued in October 1924 with a 25-year maturity period, with J.P. Morgan & Co. acting as syndicate manager. Tailored to the individual preferences of national investors, the loan was issued in nine different tranches and denominated in five different currencies. To provide an attractive yield, the coupon rate was set at 7 percent and the issuance price at 92 percent of face value. The US tranche of $110 million was issued in New York and accounted for one-half of the total planned issuance. Tranches denominated in sterling were issued in the City of London ($50 million) and in Belgium, France, Germany, the Netherlands, and Switzerland (sterling component of the Swiss tranche), for a combined equivalent of around $40 million. The rest of the loan was placed in domestic currency in Italy, Sweden, and Switzerland (domestic currency component of the Swiss tranche).

For the US dollar tranche only, the loan promised a redemption bonus of 5 percent of face value and included a gold clause. The tranche’s yield, at close to 8 percent, was about double that of long-term US government bonds. In the end, the US dollar tranche was oversubscribed nearly 10 times over and sold in 15 minutes. In initial trading, its price quickly rose to a premium. Selling the continental European tranches, however, proved more difficult. The banking syndicate sought a broad constituency for the loan, including investors in countries affected by the war. However, they did not anticipate the intensity of public resistance to lending to Germany.45 Both the Morgan bankers, in their capacity of syndicate managers, and the national authorities had to make considerable efforts to engage local banks and issuing houses in the underwriting.

The Young Plan

The Dawes Plan left open the question of Germany’s reparation liabilities. In September 1928, a new committee of financial experts was set up to draw up proposals for a complete and final settlement of the reparation problem. The Young Plan reduced Germany’s annual reparation charges; set an end date for the scheme; and introduced a new transfer mechanism. The responsibility for the collection and transfer of reparation payments was given to a new international institution, the Bank for International Settlements (BIS). The BIS, which was owned by the main European central banks, was also named Fiscal Agent of the Trustees of the Dawes Loan, assuming responsibility for the distribution of interest and amortization payments on the loan.

The Young Plan also encouraged partial commercialization of Germany’s reparation obligations.46 The Young Plan entered into force on May 17, 1930, retroactively replacing the Dawes Plan from September 1, 1929. In addition to the direct benefit of receiving $100 million dollars from the loan proceeds, Germany stood to gain from improved credit conditions domestically and abroad. The Allied countries were to receive $200 million as first installment of the revised reparation obligations.

Once again, international bankers negotiated the detailed terms of the international loan, reaching an agreement in June 1930. The loan was issued with tranches placed in nine different markets, including a German tranche, and denominated in nine different currencies. Two-thirds of loan servicing costs were covered from reparation annuities, backed by a collateral guarantee on specific tax revenues; the remaining costs were covered from general government revenues. The loan carried a 5½ percent annual coupon and was intended to be redeemed gradually through a sinking fund over a 35-year period, with final maturity in 1965. In contrast to the Dawes loan, which only carried a gold clause for the dollar tranche, the Young loan included gold clause guarantees for all tranches. As additional protection, holders had the option to collect payment of interest and principal in any foreign market where loans were quoted in the currency of that market.

In the US, 36 financing houses participated in the distribution of the $98.25 million tranche under a syndicate led by J.P. Morgan & Co. Bankers set the issuance price at 90 percent of par to attract investors but found it challenging to sell the bonds even at that price. The deteriorating international economic environment and concerns about the sustainability of Germany’s large external obligations discouraged investors. Following the offering in June 1930, the loan saw its price quickly drop in secondary markets to around 70 percent of par at the end of 1930.47

In June 1932, Allied countries, joined by British Commonwealth members and smaller European countries, signed an agreement to suspend German current reparation payments and replace them with a new schedule of reduced obligations. The Lausanne Agreement explicitly safeguarded the service on Dawes and Young loans. In Article 7, the signatory governments declared that “nothing in the present Agreement diminishes or varies or shall be deemed to diminish or vary the rights of the bondholders of the German External Loan, 1924, or of the German Government International 5½ percent Loan, 1930.”48

In December 1932, the US Congress adopted a resolution that no foreign debt owed to the US government should be reduced or cancelled (see Chapter 1 on the US). The German government did not make further reparation payments, and the Nazi regime abandoned the Versailles Treaty in 1933, repudiating the reparation obligations under the treaty. Despite the growing internal opposition, continued service of the Dawes and Young loans initially was not in doubt. It was well understood that these loans were “the touchstone of German credit” and that Germany had taken on a special commitment to pay.49 However, this resolve was not to last long.

Toward Full Control of Foreign Trade and Foreign Exchange

In the 1930s, the German government moved in three stages to fully control foreign trade and foreign exchange transactions. Initially, the government wanted to safeguard its scarce foreign exchange reserves but understood that it was not in its best interest to default on all its foreign debt. Combining debt management and trade and exchange control policies, it continued servicing its foreign debt in domestic currency equivalent. However, the protective provisions of the Dawes and Young loans were suspended, including the gold protection and pari passu clauses, and the BIS was sidelined.

Eventually, the foreign debt issue was turned into a transfer problem. The government used bilateral trade concessions to play creditor countries against one another, differentiating between debt instruments, while recognizing the special status of the Dawes and Young loans. In doing so, it avoided any formal default sanctions. The German strategy was supported by the broader international trend toward protectionism, bilateralism, and foreign exchange controls.

Step One: The 1931 Exchange Controls

To provide protection against the international financial crisis and limit capital flight, the German authorities introduced exchange controls in mid-1931 through a series of emergency decrees.50 A standstill agreement for short-term foreign currency debt froze the redemption of such debt but allowed for interest payments in foreign exchange. Interest and amortization on long-term foreign currency debt remained convertible in principle but had to be channeled through the Reichsbank and was subject to foreign exchange transfer restrictions.

The transfer restrictions on servicing long-term foreign currency debt depressed prices in foreign secondary markets relative to those in the German markets.51 Servicing of the Dawes and Young loans was not subject to transfer restrictions, but their secondary market prices abroad dropped in tandem with those of Germany’s other long-term foreign currency debt, reflecting investor concern about possible future restrictions. Prices of the US dollar and pound sterling tranches of the Dawes and Young loans in different national markets started to diverge (Figure 6.11). Recognizing that price differentials between foreign and domestic markets could be exploited as a tool for export promotion, the government created legal schemes for encouraging repatriation of German bonds (Box 6.1).

Figure 6.11.Secondary Market Prices of Dawes and Young Loans in Different Markets, 1931–38

(100 = Par)

Source: Moody’s Analyses of Investments, various issues.

Step Two: The 1933 and 1934 Transfer Moratoriums

Once in power, the Nazi regime sought to reduce service on the Dawes and Young loans to preserve scarce foreign exchange reserves for public works and rearmament. The government imposed a moratorium on the servicing of all long-term foreign debt, initially continuing to exclude the Dawes and Young loans. German debtors were instructed to make all foreign debt service payments in domestic currency at the official exchange rate to the newly established Conversion Bank for Foreign Debt.

Foreign creditors received a corresponding claim on the Conversion Bank for Foreign Debt, but the payment in foreign exchange was left to the Reichsbank’s discretion. The Reichsbank paid foreign creditors one-half of the interest claim in foreign exchange; the rest was paid in RM-denominated scrip52. The foreign exchange portion was eventually reduced to 30 percent. Payments on the Dawes loan were serviced in foreign currency, as protected by an explicit transfer guarantee. Interest payments, but not amortization, were paid on the Young loan.

In tandem with the 1933 transfer moratorium, preferential treatment was offered to holders of German securities abroad in exchange for specific trade concessions. Agreements were reached with the Netherlands and Switzerland, granting foreign holders in these countries the right to convert scrip in foreign exchange at no discount. In return, trade concessions were provided to help maintain Germany’s trade surplus with these countries. Other creditor countries, the US most vocally, rejected preferential holder treatment and insisted on equal treatment of all holders. The US, however, was unable to convince the Netherlands and Switzerland to maintain a unified creditor country front.

Box 6.1:Repatriating German Bonds

Initially, German exporters could only use export proceeds to repatriate their own debt. The 1932 regulations expanded this scheme. German exporters, irrespective of whether they had debt outstanding abroad, could repatriate German bonds to generate “additional exports.” Against the background of widespread currency devaluations, exporters had to demonstrate that they needed special incentives to compete with foreign competitors. Subject to this condition being met, a permit was granted to use a portion of export proceeds to purchase German bonds abroad and sell them domestically. This portion was calibrated to offset the estimated profit on the bond repatriation against losses accruing from the unfavorable official exchange rate.

Any German bank authorized to deal in foreign exchange could act as an intermediary in the repatriation. Exporters could sell to the banks a portion of the export proceeds authorized for bond repatriation, called export valuta. A market for export valuta developed, carrying a premium over the official rate of exchange. This depended upon the discrepancy between the prices for German securities in foreign markets and in Germany. The exchange control authorities maintained strict control over the repatriation scheme, in part to prevent speculation.

Premium Quotations for Export Valuta, August 1933–August 1934
1933Percent1934Percent
August22.0January48.5
September24.8February49.5
October25.0March53.0
November20.5April58.5
December29.5May56.5
June100.0
July115.0
August150.0
Source: Hamburger Welt-Wirtschafts-Archiv, various issues.Note: The quotations are end of month values.
Source: Hamburger Welt-Wirtschafts-Archiv, various issues.Note: The quotations are end of month values.

In July 1933, the government introduced an alternative export support scheme. Foreigners could convert blocked foreign exchange balances into scrip. This, in turn, could be sold at 50 percent of its official foreign exchange face value. German exporters could buy scrip at 55 percent of RM face value and redeem it for foreign exchange at full RM face value from a dedicated government agency. The scheme was essentially an export subsidy funded by the discount at which foreigners liquidated blocked foreign exchange balances. As the new scheme developed, export support through repatriation of German bonds at a discount lost importance, and the exchange control authorities issued permits for bond repatriation in fewer cases.

The repatriation of bonds with export proceeds was eventually abolished in 1934. Exporters were subsequently required to hand over all proceeds to the Reichsbank. The latter could, however, release a portion of the foreign exchange for the repatriation of bonds if the exchange control authorities recommended doing so. The foreign exchange released could no longer be sold to others as export valuta, and the export valuta market shut down.

In June 1934, the German government suspended transfer of interest payments on all foreign debt, including the Dawes and Young loans. For these two loans, the RM equivalent of interest payments was to be paid into a Reichsbank account, effectively eliminating their special status. By this time, almost one-half of the US tranche of the Dawes loan had been repaid, but other tranches had not been redeemed. Most of the Young loan, however, was still outstanding.53 The government also wanted to replace the collective transfer mechanism, another key provision of the Dawes and Young loans, with separate bilateral payment mechanisms. The German Clearing Office or the Reichsbank was to make interest payments directly to the lead issuing banks in each of the countries where the tranches had been sold.54

Interest payments on the two loans essentially became a function of place and currency of issue, and of residence and nationality of the bondholders.55 Reflecting Germany’s negotiation power, the arrangements were detailed and complex, carefully tailored to individual country conditions (Table 6.1). Most creditor countries negotiated comprehensive clearing arrangements (including Belgium, France, Italy, the Netherlands, Sweden, and Switzerland). Residence mattered in the arrangements with Belgium, Italy, the Netherlands, and Sweden. But both residence and nationality were considered in the agreements with France and Switzerland. Germany and the UK concluded mutual transfer and payments agreements that did not introduce full clearing but entitled residents in the UK and British subjects of the British Empire to full payment of Dawes and Young coupons through other elaborate mechanisms.56

Step Three: The 1934 “New Plan”

The September 1934 “New Plan” marked the final step to full government control of Germany’s external economic and financial transactions. Under the plan, the government determined what could be imported and exported, in what quantities, for what means of payment, at what prices, and from and to what countries. The plan merged external debt and foreign currency management with trade planning to restrict and direct demand for foreign currency. This included severe restrictions on the servicing of Germany’s foreign debt.

Table 6.1.Excerpts of Trade and Transfer Arrangements by Creditor Country, 1934
Belgium-LuxembourgUKFranceItalyNetherlandsSwedenSwitzerland-Liechtenstein
Related (Included) PaymentsTransportation of GoodsGoods from Belgium, Luxembourg, the Belgian colonies, and mandated territories; that is, goods that were produced or substantially transformed in one of these regionsGoods certified by the British Chamber of CommerceFrench goods and goods from the French colonies, protectorates, and mandated regionsItalian goods; 1 additionally, raw and processed sponges from Italian coloniesDutch goods and goods from Dutch overseas territories.Swedish goodsSwiss and Liechtenstein goods
Additional Costs Associated with Transportation of Goods between the CountriesNo, as long as it is not included in sales priceFreight costs of the above-mentioned goodsIncoming special regulation with preferred payments of transportation costs, customs and harbor costs; different from provisions; see SDMEF 176/34 Currency Control Office Act/35/34 Supervisory Board Article XYes, but not for freight and other additional costs of water transportYes, freight is regulated by special agreementYes, including freight, but not transport insurance premiums and freightYes, but not transport insurance premiums and freight
Miscellaneous Costs of TradeProcessing fees due after April 30,1935; otherwise noneNoneAssembly costs, reimbursement, discounts, collection costs, special regulation similar to transportation costs. Finishing and clearing transactionsTransit fees, balances of post accounts (management); patent payments and similar; all through the account “Various transfers.” Clearing and business expenses through collective account; latter also through travel accounts (see Travels)Contract processing fees; internal water transport, balances of post account (management); patent fees, license fees, and so on after verificationConstruction management and assembly fees, patent fees, licenses, balances of post accounts (management) according to special arrangements; other expenses of German-Swedish trade; no business tripsTransaction fees; various works and fixtures; delivery of electricity; licenses and other nonma terial services (and those due August 1, 1934); additional costs of transit; income; wages; management allowances
Other PaymentsNoneNoneNoneMiscellaneous payments should be negotiated with settlement agenciesIn case of accidents insurance payments, pension payments, and so onIn case of accidents insurance payments, pension payments, heritageAll other payments, except for small border transport, interest on Swiss debt denominated in francs, insurance services; social transfers, pensions, capital payments in hardship through travel accounts
TravelsNoneNoneNoneSpecial agreement; see paragraphs 3 and 4 in preliminary remarks for IV 52 of DCCSpecial agreement; see paragraphs 3 and 4 in preliminary remarks for IV 52 of DCCNoneSpecial agreement; see paragraphs 3 and 4 in preliminary remarks for IV 52 of DCC
Special Regulations for Other PaymentsService of Debt under the Transfer BanSpecial transfer agreement; see paragraph 11 and following in Article 3 of LREPO. Transfers of Imperial loans and private external obligations up to 4.5 percent in accordance to the amounts in belgas accumulated in the special accountSpecial transfer agreement for imperial loans. For private external obligations, general regulation is applied with known exceptions (4 percent interest on funded bonds; denominated in British pounds); see paragraph 11 and following in Article 3 of LREPOSpecial transfer agreements for imperial loansSpecial transfer agreements for imperial loansSpecial transfer agreement; see paragraph 11 and following in Article 3 of LREPO.Transfers of imperial loans and private external obligations up to 3.5 percent from proceeds of certain export transactions; furthermore, an extra 2 percent in funded bonds (subject to 4 percent; denominated in guilders) or in German marksSpecial transfer agreement for Imperial loans (including Kreuger loan) and private external obligations; see paragraph 11 and following in Article 3 of LREPO. Transfers of Dawes and Young, Kreuger, and private loans up to 4.5 percent from the balances of clearing agreementSpecial transfer agreement; see paragraph 11 and following in Article 3 of LREPO. In the first place, funded bonds (4 percent; denominated in Swiss francs). Partial payments from special transfer fund to cover interest and proceeds from imperial loans and private external obligations up to 4.5 percent
Capital RepaymentsNoneNoneNoneNoneNoneNoneIn case of hardship through travel accounts
Old Trade ObligationsOld Trade ObligationsPartially by payments to the special account, partially from the special account designated by the clearing agreement; see paragraph 12 in Article II of preliminary remarks for IV 1 of DCCSpecial regulation; see paragraph 13 in Article II of preliminary remarks for IV 1 of DCCProcessing through a French trustee’s account; see paragraph 15 in Article II of preliminary remarks for IV 1 of DCCNoneProcessing through a Dutch trustee’s account; see paragraph 16 in Article II of preliminary remarks for IV 1 of DCCProcessing of clearing transactions; see paragraph 18 in Article II of preliminary remarks for IV 1 of DCCFor old obligatory expenses of non-Swiss goods, coverage is provided through a Swiss trustee’s account; see paragraph 19 in Article II of preliminary remarks for IV 1 of DCC
Source: Hartenstein (1935).Note: US had no agreements at the time.DCC = Directives for Currency Control (February 4,1935); Richtlinien fur die Devisenbewirtshaftung vom 4.Februar 1935 (RGBI. I G. 119); LREPO= Law Regulating External Payment Obligations (June 9,1933);Gesetzuber Zahlungsverbindlichkaiten gegentiber demAusland vom 9. Juni 1933 (RGBI. I G. 349);SDMEF = State Decree of Minister of Economic Affairs; Bunderlaß des Reichswirtschaftsminister.Belgas = New currency put into circulation by Belgium from 1926 until 1946
Source: Hartenstein (1935).Note: US had no agreements at the time.DCC = Directives for Currency Control (February 4,1935); Richtlinien fur die Devisenbewirtshaftung vom 4.Februar 1935 (RGBI. I G. 119); LREPO= Law Regulating External Payment Obligations (June 9,1933);Gesetzuber Zahlungsverbindlichkaiten gegentiber demAusland vom 9. Juni 1933 (RGBI. I G. 349);SDMEF = State Decree of Minister of Economic Affairs; Bunderlaß des Reichswirtschaftsminister.Belgas = New currency put into circulation by Belgium from 1926 until 1946

A June 1936 law declared that any gold clause in foreign debt contracts was not applicable, “where devaluation has occurred in the foreign currency in terms in which a loan raised abroad is payable—with or without a gold clause—such devalued currency shall be the standard of payment of the debtor’s obligation.”57 German debtors were, however, taxed at a 75 percent rate on any profits obtained from discharging foreign currency obligations at a devalued exchange rate. Subsequent legislation clarified that German debtors could fully discharge all interest and principal on foreign currency loans in RM and would owe no more than 4 percent interest on any outstanding RM obligations.

Germany continued to use bilateral negotiations with individual countries to service Dawes and Young loans. For instance, the November 1934 Anglo-German Payments Agreement gave residents in the UK and subjects of the British Empire preferential coupon payments on both loans until the beginning of WWII. At the end of 1935, the German authorities unilaterally reduced the coupons on the US dollar loan tranches held in the US, from 7 percent to 5 percent on the Dawes loan and from 5½ percent to 4 percent on the Young loan.

Even during WWII, Germany continued to tailor interest payments on the two loans. Notably, they paid partial interest on the Swedish and Swiss tranches throughout the war as part of broader efforts to maintain trade ties with the two neutral countries. Interest payments were suspended to countries that were considered hostile or that were occupied: in 1939 for British and French bondholders, from 1940 for Dutch and Belgian bondholders, from 1941 for US bondholders, and from 1942 for Italian bondholders. Technically, this policy was another violation of a provision in the Dawes and Young loans that guaranteed payment in times of war and to subjects of hostile states.

Conclusion

Throughout the interwar period, the German sovereign attempted to obfuscate the extent of its financing needs and level of indebtedness. Efforts to camouflage the true size of its obligations, however, took a more ominous turn under the Nazi regime. The regime decided to circumvent the formal budgetary safeguards from the Weimar Republic, including suspending the publication and discussion in Parliament of annual budgets fiscal accounts and having the Executive grant itself the authorization to borrow. It introduced new domestic financing instruments and mechanisms that deliberately misrepresented the government’s financial position and the use of debt to fund rearmament efforts. It manipulated price indices to keep the population misinformed about the underlying inflationary pressures from rearmament. It misled foreign creditors on its intentions to service the Dawes and Young loans. Until 1939, the regime maintained illusory formal Reichsbank independence to avoid any popular discontent about a possible return to the financing practices of the early 1920s.

The Nazi regime episode unfortunately further illustrates that a lack of honesty in fiscal matters can be part of a broader pattern of a lack of integrity in other matters—with dire consequences. The German bureaucracy, which condoned fiscal manipulations, conditioned themselves to accept larger and more blatant manipulation, deceit, and intimidation.58 Fiscal non-transparency was only one part of a policy that extended more generally into more perilous realms.

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1Excerpt from a public speech delivered on November 29, 1938, which was quoted at the Nuremberg Trial; see http://avalon.law.yale.edu/imt/05–03-46.asp.
2The government budget constraint links the monetary authority’s choices of money growth and the fiscal authority’s choices of spending, taxation, and borrowing. Whenever borrowing is the source of fiscal financing, the government budget constraint also serves to link current monetary and fiscal choices to expected future monetary and fiscal policy variables.
3James (1989) provides an analysis of government financing policies under the Nazi regime from the perspective of Keynesian economic thinking, and James (1999) puts the role of the Reichsbank in this period in its broader historical context.
4Schacht (1956) wrote an autobiography, entitled Confessions of an Old Wizard. An earlier biography calls him a “magician” (Mühlen 1938), albeit with a more negative connotation.
5Hollyer, Rosendorf, and Vreeland (2018) offer a general analysis of the incentives for autocratic regimes to be transparent and provide economic information.
6From September 1914 to October 1918, more than 80 billion marks of medium- and long-term war bonds were sold, mainly to domestic investors. Nine loan series all carried a 5 percent coupon and could be redeemed from October 1, 1924, at the earliest. Two war bonds issued in 1914–15 carried a 5 percent coupon and were redeemable in five to six years. The war bonds sold in 1916–18 had a 4.5 percent coupon and a much longer redemption period (up to 50 years).
7See Sargent (1982) for a compelling account of the hyperinflation and subsequent stabilization.
8To facilitate its acceptance as the reference unit of account, the value of the Rentenmark was determined relative to gold and set equal to the gold value of the prewar mark.
9Sargent (1982) emphasizes the importance of the change in fiscal policy regime and monetary and fiscal policy coordination for the successful ending of the German hyperinflation.
10Schultzenstein (1930). For a broader discussion of the role of the debt agency against the background of Germany’s fiscal framework under the Weimar regime, see Neumark (1929).
11When Germany formally joined the League of Nations in September 1926, it provided economic and financial data, including government debt data, to the League’s economic services.
12The prewar gold parity against the US dollar also served as the benchmark for the issuance of the Rentenmark in 1923.
13For details on how Notgeld backed by US dollar–linked Treasury bills functioned, see Keller (1954), Wilhelmy (1962), and Rowley (1994).
14For a detailed discussion, including the political economy aspects, see Hughes (1988).
15July 1, 1920, was set as the date dividing “old” from “new” holders because old holders carried proof of having registered their security holdings under the October 1919 regulations against capital fight. New holders could swap mark debt for loan liquidation debt but were not entitled to drawing rights (see Neufeld 1926, for a detailed description).
17At an issuance price of 92, the bonds carried an initial yield of 5½ percent (assuming no early redemption). Out of the 500 million RM offered, only 300 million RM were sold publicly. The residual 200 million RM were privately placed with public sector institutions and not tradable for nine months.
19The placement of new mortgage bonds denominated in gold mark offering inflation protection continued. Re-introduction of the exemption of foreign bond fotations from capital yield taxation, however, helped German borrowers float large quantities of bonds abroad (Balderston 1993).
20Notverordnung from July 26, 1930 (Reichsgesetzblatt 1930 I, S. 311).
21Reiter (1967) includes an historical overview of the role of German commercial banks in lending to government, including during this financial crisis episode.
22Contemporaneous estimate from Benjamin (1934).
23As the Debt Council continued to oppose government borrowing that was not approved by Parliament and Chancellor Brüning lost political support in Spring 1932, the government cancelled plans to issue another special decree with an authorization to borrow. Instead, it asked Parliament by law to authorize the Finance Ministry to borrow up to 600 million RM, in line with Article 87 of the Weimar Constitution. The use of special decrees, however, had eroded the principle that the budgetary powers of Parliament were constitutionally protected. When Chancellor Brüning resigned at the end of May 1932, the new Chancellor, Von Papen, again resorted to special decrees under Article 48 of the Constitution to conduct fiscal policy and borrow.
24Pontzen (2009). The Akzept und Garantiebank was founded on July 28, 1931. Its aim was to maintain or reopen access to central bank credit for financial institutions facing difficulties. It provided credit through the acceptance and discounting of bills of exchange and was not allowed to provide direct loans.
25For additional information on this recapitalization, see Balderston (1991) and Born (1967).
26Ziegler (2011) assesses total state support for Danat/Dresdner at 753.4 million RM and for Commerzbank at 112.7 million RM.
27The financial sector redeemed according to schedule the special Treasury notes received in 1931–32 and repaid the Akzept und Garantiebank.
28An estimated 263 million RM in tax remission certificates in October–December 1932 and an additional 952 million RM in 1933. More than half of outstanding certificates were redeemed by April 1939; see Golla (2008) and Oshima (2006).
29The bills carried the same rate as medium-term Treasury certificates, the 4 percent Reichsbank discount rate.
30An estimated 1 billion RM employment creation bills were issued in 1933 and an additional 1.5 billion RM in 1934; see Golla (2008).
31The February 27, 1935, Conversion Law reduced the coupon on outstanding Reich bonds to 4½ percent and extended the new coupon ceiling to all other public sector long-term issues. Outstanding employment creation bills were also consolidated through a 28-year loan floated at 4½ percent. In combination with the Conversion Law of January 24, 1935, which imposed a 4½ percent coupon ceiling on private sector long-term debt, the February law eliminated any scope for a higher coupon on alternative investments than on converted Reich bonds.
32In a May 3, 1935, memorandum to Hitler on the financing of armament, Schacht took the planned increase as a given, noting that “accomplishment of the armament program in regard to speed and extent, is the task of German policy, and that therefore everything else must be subordinated to this aim” (reported in the Nuremberg Trial Documents, Nazi Conspiracy and Aggression, Volume 2, Chapter XVI, Part 12).
35The stock of rediscounted Mefo bills at the Reichsbank rose by an estimated 4 billion RM during 1934–37, but currency in circulation increased by less than 1.8 billion RM, growing broadly in line with real economic activity.
36The German Finance Ministry prepared debt reports for internal use that documented many of the camoufaging practices—see Archiv des Ehemaligen Reichsfnanzministerium (1949). These reports served as the basis for several studies of German financial policies under the Nazi regime initiated after WWII—see, for instance, Dieben (1949) and Löbbe (1948).
37The main exception was military spending, which by an April 4, 1933, Cabinet decision was exempted from standard budget rules and brought under the direct control of Nazi leadership; see Oshima (1980).
38One week later, the Cabinet authorized sovereign borrowing of up to 600 million RM. Gesetz über Erteilung von Kreditermachtigungen approved by the Cabinet on March 30, 1933 (Reichsgesetz-blatt 1933 I., S. 151), which effectively replaced the Gesetz über Schuldentilgung und Kreditermachti-gungen approved by Parliament less than one year before.
39Steiner (2003 and 2005) presents a detailed discussion of the price controls introduced under the Nazi regime and the distortions in the reported price indices.
40Unlike special bills, the new bills were not eligible for rediscount at the Reichsbank. They still had most of the features of commercial bills, carried 3 percent interest, could be discounted at commercial banks, and were eligible as collateral for Reichsbank advances at up to 75 percent of their value.
41Government bodies and public sector companies had to use the certificates to pay for 40 percent of orders above 500 RM and purchase them for cash from the Reich Treasury, giving the Reich access to their liquidity. Suppliers and contractors had to accept the certificates in payment from government and public sector companies and from other suppliers and contractors for 40 percent of any amount due for goods delivered or services performed.
42Initial war issues of the certificates in March and May 1940 were expected to mature after 5 and 10 years, respectively; later issues from September 1940 had a maturity of 21 years.
43de Cecco (1985) calls this period “the high-noon of politicized international finance.” See also Burk (1991).
44Cable message cited in Clarke (1967).
45Most of the Continental bankers preferred their tranches be issued in sterling. The British authorities were agreeable to this, subject to the understanding that for two years such bonds could be offered on the British market only with the consent of the Bank of England.
46According to the Dawes Plan, only about one-third of each annuity (approximately 660 million RM, or $165 million) was “unconditionally” payable (could not be postponed), and only this portion of the debt could be commercialized.
48Article 7 also specified the conditions for “any necessary adaptation of the machinery relating to the manner in which the obligations of the German government with respect to two loans would be discharged.” Any change would be subject to mutual arrangement between the German government and the BIS. On this basis, the BIS sought an amendment to the Young Loan Trust agreement, including to clarify the status of the collateral guarantees securing the service of the Young loan, but without success; see text of the Final Act of the Lausanne Conference, as reported in Federal Reserve Bulletin, August 1932, 497–502.
50For an economic and institutional analysis of the role of the German exchange rate restrictions, see Banken (2006), and Child (1958).
52Scrip could be used to support exports under the “additional exports” arrangement; see Box 6.1.
53Creditor countries used the pari passu provisions to protest against unequal treatment once bilateral arrangements were in place. They did not see the provisions as a legal tool to block payments in other countries with a more favorable treatment; see Kim (2014).
54With the exception of the US, arrangements were concluded with the UK (July 4, 1934), Switzerland (July 26, 1934), France (July 28, 1934), Belgium (September 5, 1934), Sweden (October 5, 1934), the Netherlands (October 13, 1934), and Italy (April 16, 1935).
55Accominotti, Kessler, and Oosterlinck (2017), BIS (annual issues), and Clement (2004) describe the individual arrangements in more detail. In addition, Accominotti and others show how the prices of 1924 sterling Dawes loan traded in different markets reflected market valuation of the settlements with different creditor countries. See also Papadia and Schioppa (2015) on these price differentials.
56The US was the only creditor country not to engage in any negotiations with Germany following the 1934 transfer moratorium. As a result, holders of the Dawes and Young loans issued in the US received the least favorable treatment.
57Gesetz über Fremdwährungs-Schuldverschreibungen, June 26, 1936 (Reichsgesetzblatt 1936 I., S. 515).
58The Finance Ministry in 2009 asked an independent commission to investigate the ministry’s role during the Nazi regime; taking a thematic approach, commission members have published three studies to date, including one on tax policies under the Nazi regime—see http://www .reichsfnanzministerium-geschichte.de/.

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