Did High Wages or High Interest Rates Bring down the Weimar Republic? Hans-Joachim Voth The Journal of Economic History, Vol. 55, No. 4 (Dec. 1995)

Pre-war Germany: Dynamic Economy, high Level of Savings and Investment’ Virtually no unemployment 16% of domestic product devoted to capital formation

Early 1920’s Deterioration of economic confidence, accelerating inflation  HYPERINFLATION Stabilization of currency in 1923 resulted in economic prosperity, rising output, exports, and employment’ Signs of economic weakness  investment dropped to 10.5% during second half of 1920s

Foreign capital Foreign currency needed to pay reparations could only be obtained by maintaining an export surplus or importing foreign capital In the face of capital inflows that threatened renewed inflation, Hjamar Schacht pursued a tight monetary policy which kept interest rates high (sterilization of capital inflows)

Limited investment primary reason for slump caused by either: – Excessive wages  reduced profits – High interest rates undermining capital expansion

Borchardt Excessive price of labor caused profits to slump. Hyper-inflation devastated capital market, forcing firms to use profits to finance investment Investment insufficient to deliver increasing amount of goods and services

Notice that as unit labor cost increases, expansion rate of capital stock decreases (after 1930).

Voth Findings based model suggest that the relationship between interest rates, real wages & investment is causal: Prices of capital and labor determine the rate of expansion of capital stock. Borchardt’s view is that the high price of labor discouraged investment because it squeezed firms profits However, it is also possible that high labor cost would encourage investment because the cost of labor is so high (i.e. firms would rather invest because the cost of labor is equally as high as cost of capital) Additionally, even had wages been constrained, investment would have been below historical levels by about 1/3

Error-correction model reveals no evidence of wages depressing investment Demand for capital in the German economy between 1925 and 1929 strongly reduced by high interest rates Simulation suggests that lower interest rates at the end of the 1920s would have caused significantly higher investment *Strong substitution effects between capital and labor  High wages make for high investment relative to capital stock

“If, as Schumpeter suggested, domestic capital formation was crucial in determining the overall economic performance on Weimar Germany, the the interest rates and not wage pressure were at the heart of sluggish growth” “Whatever may have been necessary to save the first German republic, the small-cake economy that- according to Borchardt- was directly responsible for its demise could hardly have been avoided through workers’ sacrifices. Instead, possible remedies for Weimar’s malaise of low investment could have been higher wages, or a return to the lower interest rates that had prevailed before WWI.”