While the aftermath of World War I was characterized by `open inflation', following World War II most of Europe opted for monetary reform at the going level of prices, and only Italy and France allowed open inflation. In Discussion Paper No. 464, Research Fellow Rudiger Dornbusch and Holger Wolf review the conceptual issues involved in monetary reforms and the historical evidence on the post-war reforms, including the German reform of 1948, which took place in a world of controlled prices, stagnant production and substantial idle money balances in many ways similar to Eastern Europe today.

Dornbusch and Wolf first note the risk that the endemic macroeconomic instability that has characterized the recent political liberalization of Latin America may be repeated following the crumbling of the East European regimes. As market forces are unleashed and controls lifted, the removal of the monetary overhang becomes critical, and it may be accomplished either by means of large-scale possibly one-shot inflation, or through a reduction of effective nominal money balances. These may be written off, consolidated as debt or retired by asset exchanges or budget surpluses. Of course, monetary reform can only deal with the stock issue, i.e. the monetary overhang: solving the flow problem, i.e. the budget deficit, requires the elimination of subsidies, reductions in public spending programmes and improvements in tax administration.

Dornbusch and Wolf distinguish three types of monetary reform. First, a simple change of numeraire in order to eliminate a number of zeros may also help to determine the wealth distribution with a view towards later taxation or elimination illegally acquired currency hoards. Second, blocking bank accounts will immobilize money holdings, possibly with a view to a subsequent write-off of the frozen assets or a forced conversion into interest-bearing, non-marketable loans, with an interest rate at the government's discretion. This avoids the lack of credibility that translates into a potentially extravagant interest rate burden in the case of a voluntary conversion.

Third, in a `confiscatory' monetary reform, currency and/or bank accounts are written off at an across-the-board conversion rate or on a differentiated basis, so that money balances are converted at a less favourable rate than flows, such as rents or wages. A uniform conversion of all nominal assets held by the public will have the same distributional effects as a blip in the price level, while a more differentiated process could accommodate desired political features such as the special taxation of speculators (who hold currency) or of affluent groups (who hold government debt and large deposits).

Most of the monetary reforms in the 1940s and 1950s differentiated by type and magnitude of asset holdings, either with the political objective of targeting groups that had gained in the war, illegally or otherwise, or simply in order to share burdens on the basis of ability to pay. An investigation of the distribution of monetary assets, therefore, was always an important consideration in designing monetary reform.

Monetary Overhang and Reforms in the 1940s
Rudiger Dornbusch and Holger Wolf

Discussion Paper No. 464, October 1990 (IM)