Radical Currency Reform: Germany, 1948
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

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European Department, IMF

In an environment of suppressed inflation, excess demand, and excess liquidity, monetary order was restored in the Western part of Germany through a radical and comprehensive currency reform

Eastern European economies that are currently implementing economic reform programs have accumulated large monetary overhangs (i.e., excess liquidity) that reflect the severe deterioration of public sector (including enterprises) finances. Their situation has been compared to that of Germany after World War II and, consequently, a currency reform modeled after the German example of 1948 has occasionally been recommended. The German experience, however, suggests that currency reform on its own does not guarantee success. Indeed, there were numerous monetary reforms in Eastern Europe between 1946 and 1953, which did not have comparable results.

In the course of the Federal Republic of Germany’s almost miraculous economic recovery, the 1948 currency reform took on mythic proportions. It has been glorified as one bold strike that led to almost instantaneous success. This is not entirely correct. A closer look reveals that the reform was a thoroughly planned, well-orchestrated, and carefully implemented measure, within a broader program for the country’s economic restructuring. But it took several years to set the stage for economic recovery.

In early 1948, the German economy was in dire straits. As a result of extensive war damage, manufacturing production was less than 60 percent of its 1936 level and real per capita consumption was about two thirds of what it had been then; there was a severe scarcity of most basic goods. Moreover, war financing had left the “Third Reich’s” public debt at the end of the war at almost 400 percent of 1939 GNP and had created a vast amount of excess liquidity. The Reichsmark (RM) had lost its function as a means of exchange, and barter trade had become the order of the day. Black markets undermined the system of price and wage controls and the production and distribution of goods. There was no incentive to work for money. Imported goods quickly disappeared from the regular markets and exporting was unprofitable since foreign currency receipts had to be surrendered against Reichsmarks.

A more comprehensive discussion of this topic is available from the authors.

Reform of the monetary system—within a broader reform of the economy—was necessary for improving the economic situation. In principle, the monetary overhang could be reduced either by allowing prices to rise while keeping the supply of money unchanged, or by cutting the nominal money supply through currency reform while keeping prices unchanged initially. Because of the severity of the situation, the political circumstances of the time, and, probably, Germany’s experience of hyperinflation after World War I, currency reform was selected as the appropriate approach. The controlled reduction in the money supply would mop up excess liquidity and reduce the risk of an inflationary spiral. It would also allow accompanying measures to offset, at least in part, the redistribution of wealth resulting from monetary reform.

Any currency reform that involves a substantial and sudden reduction of monetary assets of the private sector essentially amounts to a partial or complete default by the public sector. This has far-reaching implications for the relationship between creditors and debtors in the economy at large. A currency reform is therefore far more than the exchange of new money against old money at an arbitrarily determined exchange rate; it implies a comprehensive restructuring of the whole economy.

The blueprint

The American architects of the German currency reform plan, known as the “Colm-Dodge-Goldsmith-Plan,” had to deal with three broad issues: the design of the reform; its sequencing and implementation; and accompanying measures.

Design of the reform. A crucial step was to establish an exchange rate between the old currency and the new currency, the Deutsche Mark (DM), that would preserve the internal as well as the external stability of the new currency. The authors of the plan noted that cash and demand deposits of the nonbank sector (Ml) had increased by almost 500 percent between 1935 and 1945, while GNP had dropped by more than 40 percent. This enormous increase in money supply had been accompanied by a price and wage freeze from 1939 onwards and a system of rationing. As a result, a huge monetary overhang had emerged. To restore velocity to its 1935 level, which was considered normal, Ml had to drop by 90 percent. The architects of the reform, therefore, proposed that one DM be exchanged for ten RM in the hope that this would establish the existing price level as the new equilibrium price level. The exchange rate of the new currency against other currencies would, in principle, reflect relative prices prevailing at the time of the currency reform. Purchasing power parity of the Reichsmark at existing (official) prices was estimated at RM 3 per US dollar in 1948. Allowing for some likely increases in the price level after currency reform, the exchange rate of the Deutsche Mark was therefore set at DM 3.33 per US dollar.

The authors of the currency reform plan suggested that the 90 percent reduction formula be applied to all liabilities of the banking system to the private nonbanking sector but, for political and psychological reasons, to annul all liabilities to the Government and the Nazi party. Having thus established the consolidated liabilities of the banking system, the restructuring of the assets would be straightforward. While domestic credit to the private sector was to be converted into DMs at the same rate as bank liabilities, all credit to the previous territorial authority, the Reich, was to be annulled and replaced by debentures of the federal states. The value of these assets was to be determined in such a way that the total assets of the banking system would cover total liabilities plus an appropriate amount of equity.

The plan used the same exchange rate between the RM and the DM for liabilities and financial contracts of private nonbanks, so that debts in DM terms were reduced to one tenth of their level in RMs. The redistribution of wealth resulting from the devaluation of monetary assets was to be corrected by a system of taxes and transfer payments. For all current payments, such as wages, rents, and taxes, as well as for prices of goods and services, parity between RM and DM was established. This was necessary to achieve the desired reduction in real money balances.

Sequencing and implementation. To facilitate conversion into DM, all outstanding cash would be collected in bank accounts. The converted funds were to be released in several installments after the tax authorities examined and established the legality of the RM holdings. However, to avoid a prolonged disruption of economic activity by the exchange process, a DM advance was to be paid to households—at a flat rate—and to businesses, based on the number of employees. For a limited period, a moratorium was to be declared on all RM payment obligations.

Accompanying measures. Given the structural problems left from the centrally directed war economy and the sharp changes implied by the proposed currency reform, the authors of the plan stressed the need to implement a set of accompanying measures with a view to improving the supply side of the economy and correcting the anticipated wealth redistribution of currency reform.

To improve work incentives and encourage investment, they suggested that a considerable cut in income and wealth taxes be accompanied by a reduction of budgetary spending, in particular on existing social programs. The latter would be facilitated by the establishment of a special extra-budgetary fund (financed by a tax on real assets) to ease social hardship caused by the war and currency reform.

The depreciation of all monetary assets and liabilities by 90 percent would, at a given level of prices for goods and real assets, create large windfall gains for net monetary debtors possessing goods and real assets at the expense of net monetary creditors. Colm-Dodge-Goldsmith proposed to tax these gains, at a rate of 100 percent payable in annual installments, in the case of all private debtors and to transfer the proceeds to a special burden equalization fund. A further tax, at a rate of 50 percent levied in the same way, on the remaining net assets was suggested in order to equalize the burden of war destruction. In effect, these taxes were designed so as to redistribute purchasing power derived from past wealth to purchasing power derived from labor and business activities.

It was envisaged that nontradable, interest-free claims against the assets of the burden-equalization-fund would be issued to those who had incurred losses as a result of the war and the currency reform. Redemption of these claims would depend on the funds available and the type of loss suffered. Thus, the authorities were given two instruments to determine the eventual amount of compensation granted to an individual, the recognized loss, and the waiting period for the payment of compensation.

The implementation

The Colm-Dodge-Goldsmith-Plan was implemented in the summer of 1948 with relatively few modifications. The military government of the western occupation zone enacted three laws—the currency law, the issue law, and the conversion law—and numerous regulations that together put the currency reform into force. The currency law, in official terms the First Law for Monetary Reform, established the Deutsche Mark as the only legal tender and regulated the initial advance to each inhabitant of the western sectors of occupied Germany (DM 40 in June 1948 and DM 20 two months later) and the supply of the new currency to public authorities and businesses against payment of an equal amount of RM. Interestingly, the law did not disclose the eventual conversion rate of RM into DM—this was published only one week later in the conversion law. Moreover, advances to enterprises amounted to only 17 percent of the advances to the population. This lopsided distribution was chosen to induce businesses to sell their hoarded stocks quickly in order to obtain liquidity. The psychological effect of a sudden increase in supply of goods, it was hoped, would boost public confidence in the new currency. Eyewitness accounts confirm the success of this strategy. The law imposed a one-week moratorium (i.e., until the conversion law was published) on all RM obligations and requested that all cash denominated in RM be deposited in bank accounts for later conversion into DM. The law took effect on June 20, 1948—the day the DM advances were issued—and by the end of June, DM 4.4 billion were circulating in the economy.

The Second Law for Monetary Reform (the issue law) established the Bank Deutscher Lander (later to become the Bundesbank), which had been created in March 1948 as the head organization for the earlier established reserve banks of the states and the institution responsible for the issue of Deutsche Marks. The issue law, which took effect together with the currency law, gave the Bank Deutscher Lander responsibility for the completion of the currency reform and endowed it with the instruments of monetary policy (in particular, the instruments of minimum reserve requirements, the discount rate, the Lombard rate, and open market operations).

The Third Law for Monetary Reform (conversion law), which took effect one week later, contained the detailed regulations for the conversion of RM assets and liabilities of the banking and nonbanlring sectors. Part one stipulated that Reichsmark accounts of private nonbanks were to be converted into Deutsche Mark accounts at a rate of 10:1. One half of the DM assets was credited to demand deposits and could be accessed freely after conversion; the other half was credited to escrow accounts until a decision on its treatment was made in the course of the following 90-day period. Interbank deposits and deposits of the public sector were annulled. In line with the Colm-Dodge-Goldsmith-Plan, uncovered liabilities of credit institutions (after allowing for appropriate equity capital in the amount of 4.5-7.5 percent of DM liabilities or, alternatively, of 10 percent of RM liabilities at the time of currency reform) were balanced with debentures issued by the federal states.

Part two of the conversion law regulated liabilities of the nonbanlring sector. All debts of government agencies and the Nazi party were annulled and the remaining (private sector) RM debts were converted into DM debts at the ratio of 10:1. This regulation also applied to most financial contracts, including securities and insurance contracts. Current payment obligations, such as wages, salaries, rents, and pensions were like prices converted at a rate 1:1. The equalization of burdens was foreseen in principle, but detailed provisions were left to the German legislation to be enacted by December 31, 1948.

Soon after the currency reform laws were enacted, it became clear that there was still an excess supply of liquidity in the economy. Contrary to the assumptions made in the Colm-Dodge-Goldsmith-Plan, money velocity increased considerably above its 1935 level. In September 1948, it was therefore decided to annul 70 percent (DM 2.1 billion) of the funds held in escrow; as a result, money in circulation declined by about 2 percent between the end of September and end of December 1948. Thus, the conversion rate for currency was reduced from 1:10 to 1:15.4, and the stock of money in the hands of the private nonbanking sector was cut by 93.5 percent instead of the planned 90 percent.

In conjunction with the currency reform, largely at Ludwig Erhard’s initiative, a number of measures critical to the revival of the German economy were taken. First, most prices were liberalized. Prices for food, agricultural products, and most raw materials, however, remained controlled, and the supply of these products rationed; prices of textiles and shoes were liberalized, but the supply was also rationed. Second, rates for the income, corporation, wealth, inheritance, and tobacco taxes were lowered, with effect from June 22, 1948. Third, measures were taken to compensate those who had suffered social hardship as a result of the currency reform. However, since a “burden equalization fund” was only created in 1952, the proceeds from the windfall gains taxes (mentioned earlier) first accrued to the government, which used it to finance social expenditures. Fourth, the allied powers, most notably the United States, provided substantial financing for the reconstruction of Germany, the bulk of which was transformed into nonrepayable grants at the occasion of the London debt agreement of 1953, which also dealt with the remaining debts of the Reich.

The years after

The groundwork for the later economic success was laid in the years immediately after the currency reform, but the path to recovery was by no means smooth. Output and productivity in the Western occupied zones, which in 1949 became the Federal Republic of Germany, picked up strongly following the introduction of the DM, the partial freeing of the economy from the price freeze, and the lifting of the wage freeze later in the year. However, reflecting an initially strong and unexpected increase in liquidity, inflation surged to almost 38 percent and prompted anti-inflationary policies by the new central bank, showing some results toward the end of 1949. In the wake of trade liberalization measures taken in that year, however, the external balance deteriorated sharply and, in 1950, an adjustment program supported by the OEEC (Organization for European Economic Cooperation, the predecessor of the OECD) had to be launched. The stabilization efforts were successful, and, helped by the “Korea boom” of the early 1950s, the economic situation began to improve thereafter.

The review of the events of 1948 and the following years has illustrated that currency reform was one stepping stone, albeit a very important one, to the economic recovery of Germany. One of the main reasons for success was that it was complemented by the creation of a social market economy, which entailed price, wage, and later on, trade liberalization, combined with prudent macro-economic and social policies. Other important reasons for success were the presence of a population desperate for economic and political reconstruction and a determined central authority (in the form of a military government).

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Finance & Development, March 1990
Author: International Monetary Fund. External Relations Dept.