One question I often receive about the data for the Germany is why the German stock and bond indices had a 90% decline in June 1948. At first, people think there is an error in the data, but German shareholders actually did lose 90% of their capital as a result of the Currency Reform of June 20, 1948 when Reichsmark were converted into Deutschemark. Despite the loss, the reform benefitted shareholders. who were unable to sell their stocks at the fixed prices the Nazis had imposed during the war. Although the Currency Reform imposed an immediate loss on all shareholders and bondholders, the Reform helped West Germany to emerge from the economic collapse of World War II and begin the Wirtschaftswunder (Economic Miracle) that enabled Germany to enjoy the economic growth that occurred in the decades that followed.  

Nazi Economics

During the 1940s, the German government organized its economy with one goal in mind: to win the war. As in the United States, the government made sure that all goods essential to the war were acquired by the government at a reduced cost. The prices of consumer goods were controlled in order to limit inflation, but the inevitable result was a black market in scarce consumer goods.Not only were price controls imposed upon goods, but price floors were introduced for stocks and bonds, preventing securities from declining in value. A bombed out factory isn’t worth as much as a fully functioning factory, and industry was run to aid the war effort, not to make profits. If markets had been left to themselves, stock prices would have declined as the tide of the war turned against the Nazis. Since prices didn’t reflect the values of the shares, stock markets froze and trading dwindled until it was almost non-existent. Price floors had been introduced during World War I in London, New York, Berlin and other countries for good reason. Although stocks traded at full price, market makers only had to put up a fraction of the cost of stocks, waiting until settlement days to balance their accounts. A steep decline in prices would have bankrupted many of the stock market’s traders, so the price floors were introduced to prevent panic selling. As a result of the price floors, trading in many securities stopped since no one was willing to buy shares for less than they were worth. Consequently, between January 1943 and June 1948 there was virtually no change in the German stock market index. The Nazi government remained in default on its own bonds until 1953, introduced multiple exchange rates, and imposed capital controls to stem the flow of money out of Nazi Germany.  

The War Ends and the Economy Collapses

After the war ended in Germany, the economic situation got even worse. The money supply had expanded five-fold between 1939 and 1945, but prices of many goods were fixed. Although ration coupons were used to allocate some goods, the amounts rationed were insufficient to meet daily needs, and consumers were forced to turn to black markets.

After the war ended, the occupying powers replaced the Reichsmark and Rentenmark with a Military Mark. Although the western Allies tried to limit the issue of Military Marks to control inflation, the Soviets were more than willing to print extra marks to pay for the rising costs of occupation. For political, rather than for economic reasons, the Western Allies gave copies of the plates for the Military Mark to the Soviets who began printing excessive amounts of the notes generating inflation. Having suffered from economic collapse and inflation after World War I, Germany was facing a second collapse that might have been worse than the hyperinflationary death spiral of the 1920s.

By the spring of 1948, the German economy was collapsing. Food production was half what it had been in 1938 and industrial production was one-third of its pre-war level. With salaries controlled by the government, wages were low, and many workers failed to show up, contributing to the decline in production. Instead, people devoted their time to finding the food they needed to survive. Anywhere from one-third to one-half of all transactions were on the black market or through barter. American cigarettes were used as a more reliable currency than paper money since cigarettes held their value. Many soldiers sold their cigarettes on the black market to add to the meager salary they were receiving. Food was so scarce that on weekends, many Germans left the cities for the countryside to try and buy food directly from farmers since the shelves of stores in the city were bare. Some Germans grew food in their back yards to keep themselves from starving.  

Replacing Nazi Economics with the Free Market

With the growing tension between the western Allies and the Soviet Union, the need to revive the German economy superseded the need to pacify Germany. The reform of the German currency and economy was overseen by Ludwig Erhard who wanted to replace the government-controlled Nazi economy with one based upon the market. Erhard had refused to support the idea of a centralized economy under Hitler, and his anti-Nazi credentials helped him to secure the support of the Allies over other German economists who wanted to maintain the government controls and rationing which clearly were impoverishing the nation. Erhard advocated the ending of price controls and a currency reform which would replace the Military Mark with a new currency with a limited money supply called the Deutschemark.By eliminating the Military Mark and replacing it with a smaller supply of Deutschemark while simultaneously eliminating all price controls, Erhard hoped to end both inflation and the shortages that plagued the economy. The Deutschemark were secretly printed in the United States and put in boxes that were innocuously labelled “doorknobs” so they wouldn’t arouse suspicion. Meanwhile, factories were instructed to withhold the distribution of their goods until the currency reform was introduced so the flood of goods into stores would help the economy to revive as quickly as possible. On June 20, 1948, the currency reform was introduced. Germans, who had gone to bureaucratic offices to pick up their ration coupons, instead received 40 Deutschemark in the new currency and an additional 20 Deutschemark soon after. Germans were allowed to exchange a limited amount of their Military Marks into Deutschemarks, but most of their money was lost. Now goods would be rationed by Deutschemark, not by ration coupons.

Stocks and bonds were converted from Reichsmark into Deutschemark at the rate of 1 to 10. A bond or stock that had been worth 100 Reichsmark was now worth 10 Deutschemark. In effect, the government imposed a 90% loss on all securities. This is why GFD’s German stock and bond indices show a 90% drop in 1948. Though investors suffered losses, consumers were ecstatic. The effect of the currency reform was immediate. Within a week, store shelves were full, black markets were eliminated, and economic stability returned to Germany. The politics, however, were not so simple.  

Germany Separates into West Germany and East Germany

The United States and Britain had not informed the Soviet Union of their plans to reform the German economy and introduce a currency reform. The Reichsmark and Military Mark became worthless overnight in the Bizone (areas controlled by the U.S. and the U.K.), so the old marks began to flood into the Soviet Zone. This forced the Soviets’ hand, and a couple days later, the Soviets introduced their own currency reform, first adding a stamp to currency to validate it, and several months later, introducing new banknotes into circulation.

The Ostmark was introduced in East Germany and continued to circulate in East Germany for the next forty years. Although the official exchange rate between the Ostmark and Deutschemark was set at one-to-one, the Ostmark always traded at a discount. I remember when I visited East Berlin in 1986, the black market rate was 5 Ostmark to the Deutschemark, but visitors to East Berlin had to exchange 25 Deutschemarks for 25 Ostmarks (which looked like monopoly money) as the price of entering East Berlin to see the walls of Babylon at the Pergamum Museum. The Ostmarks had to be spent in East Berlin, and since I was thirsty, I bought a glass of Vita Cola, the East German version of Coca-Cola, a drink which made cod liver oil taste delicious by comparison. Vita Cola kept the formula for their soft drink secret, but more likely to protect the rest of the world rather than to hide trade secrets.

The currency reform only applied to the three zones occupied by the United States, Britain and France, but not West Berlin. The Soviets followed the currency reform with a blockade of all roads into the Soviet zone making West Berlin inaccessible. The Currency Reform of June 1948 led directly to the Berlin Blockade and the airlift that saved the people of West Berlin from starvation. Along with the airlift came the Deutschemark which became the official currency within West Berlin. After June 1948, the economic and political separation of Germany became a reality and continued until the fall of the Berlin Wall in 1989. The currency reform was a success. As the economy recovered, the stock market quickly rose in value as well. The German stock index recovered its pre-Currency Reform level by 1952. On February 27, 1953 Germany officially defaulted on its foreign debts, replacing old bonds with new ones which had a lower interest rate and an extended maturity. Capital controls were soon lifted and the Deutschemark became a strong currency that enabled Germany to recover. Of course, stocks were never allowed to trade in East Germany. Its citizens would have been happy to have temporarily lost 90% of the value of their investments and see their capital eventually be returned in whole. Instead, East Germans lost everything, and had to wait forty years before their currency was replaced by the Deutschemark.

 

Overend, Gurney and Co. was formed in 1805 by the merger of Richardson, Overend and Co., originally founded by Thomas Richardson in 1802, and Gurney’s Bank located in Norwich and founded in 1770. Thomas Richardson developed the bank’s business for discounting bills that became the foundation of the firm’s profits. Overend, Gurney and Co. soon became known as the banker’s bank since they discounted the bills issued by other banks and held them until maturity, and made loans against bills issued by other banks. Between 1825 and 1865, Overend, Gurney and Co. was the greatest discounting house in the world. Only the Bank of England could match its resources. Discounting was a reliable business that made consistent profits, but not content with the steady income from discounting bills, the bank wanted to expand into presumably more profitable investments. The only certain thing about a bank moving into uncertain investments is the certainty that the bank will probably end up losing money, which it did. <3>How to Ruin a Good Business England was going through one of its periodic railroad booms in the 1860s with opportunities for profitable expansion also occurring in shipping, mail delivery, and other transportation activities. Between 1859 and 1862, the Quakers turned their back on the sound banking policies that had made their bank successful and managed to find speculative investments that won them the equivalent of a financial Darwin award. It is amazing how a bank that could be so conservative in one area could be naïve enough to get involved with scammers who promoted projects that made themselves money, but were otherwise doomed to failure. The bank advanced money to invest in plantations in Dominica that grew little food, financed a railway line across the wilds of Ulster where there were few passengers, invested in the Greek & Oriental Steam Navigation Company which was unable to develop its business, failed to get the mail service for the Galway Line and foolishly invested in the Millwall Iron Works on the Isle of Dogs which generated losses, not iron. The last three investments cost the bank around £5.2 million. As Walter Bagehot, then the editor of The Economist said, ”one would think a child, who had lent money in the City of London would have lent it better.” As a result of these investments, the bank had liabilities of around £4 million, and liquid assets of only £1 million. As the losses mounted, Overend needed capital to keep the bank solvent. The company decided to go public and issue shares as a way of raising enough money to cover their losses and return to a profitable future. The bank converted itself into a limited liability company, and offered 100,000 shares to the public at a par of £50, requiring £15 up front and reassurance that an additional call on capital would be unlikely. Of course, the prospectus never mentioned the consequences of the bank’s bad investments, the excessive liabilities, and other problems, but focused on its strong reputation and the potential profits of the company.  

When Limited Liability Adds Insult to Injury

Overend, Gurney & Co. stock started trading on August 21, 1865, and hit a high of 22.5 on November 16, 1865. As the price rose, investors who had missed out on the initial offering bought shares, keeping the price around 20; however, they were unaware of the rot that lay beneath the façade of the bank. By the end of February, 1866, shares still traded above 20, but began to drift down, falling below 15 by late April. In April, the investment in the Millwall Iron Works on the Isle of Dogs began unravelling, producing £500,000 in unexpected losses for the bank. The financial markets in London were reaching the heights of a small bubble, and the Bank of England responded by raising the lending rate from 6 per cent to 7 per cent on May 3, to 8 percent on May 5 and to 9 per cent on May 11 and 10 percent on May 12. As money tightened, Overend tried to raise capital by collecting on debts owed to it by the Mid Wales Railway and others, but when the bank was unable to get this money, it became evident that the bank would soon become insolvent. Overend’s only alternative was to go to the Bank of England, which as lender of last resort, could have bailed out Overend, Gurney and Co. However, the Bank of England declined, not because allowing Overend to fail would reduce the amount of competition the Bank of England had, but because Overend was in such poor shape that no amount of money could have saved it. On May 10, 1865, the bank announced that it was suspending payment on deposits. The price of the stock had closed at 10 on May 10, fell to 3.5 on May 11 and to 0.5 on May 12. Until then, few had suspected that the greatest name in wholesale banking could have collapsed so suddenly. If Overend, Gurney & Co. was unsafe, could any bank be safe? A financial panic ensued and during the next few months, over 200 companies, including many banks, failed as well.