Standard economic thinking holds that governments can only raise money through two means. These are to raise taxes or to borrow money. For Germany in 1934, neither was palatable. Taxes were unpopular, while borrowing was already stretched funding public programs. How then could Germany finance the rearmament of its military, all while subject to the Treaty of Versailles?
The MEFO bill provided the answer to this complex question. By 1939, Germany had revitalised its industrial capacity and arms capacities. Clearly, the MEFO bill had worked wonders. Such remarkable economic policy warrants analysis.
In this article, I consider seven key questions:
- How did the MEFO bill work?
- Was the MEFO bill money printing?
- What was the economic effect of MEFO bill repayment?
- Why wasn’t the MEFO bill inflationary?
- What is the economic intuition behind the MEFO bill?
- Did the repayment of MEFO bills necessitate war in 1939?
- What would a modern MEFO bill look like?
How did the MEFO bill work?
Metallurgischen Forschungsgesellschaft (meaning ‘metal research society’) was a front company set up by the German government for rearmament. It would purchase military arms on behalf of the government and pay with MEFO bills. Such bills promised to pay their full value in cash. The typical term of a MEFO bill was 6 months, but it could be extended in 3-month periods indefinitely. In the meantime, they paid interest of 4% annually to compensate the holder.
For example, if MEFO bought 100 tanks worth $10 million, it would pay with a $10 million MEFO bill. In theory, after 6 months, it would pay back $10 million in principal and $200,0000 in interest, totalling $10.2 million in Reichsmarks (cash). If extended, it would only pay back $200,000 at 6 months as interest, and the $10 million paid at a later date.
The organisation of MEFO is unintuitive. Therefore, we will use commonsense questions to illustrate the genius of the MEFO bill.
Why use a front organisation to pay for arms?
The Treaty of Versailles prohibited a high level of German military spending. The German government used a front organisation to buy arms to avoid accusations of infringing the Treaty of Versailles.
MEFO also hid the extent of arms spending. Instead of arms spending manifesting in government figures, it was hidden on the balance sheet of a private company. This helped to maintain public confidence that the government was not engaging in ‘reckless spending’. Otherwise, if the full degree of military spending became obvious, the public would have lost faith in the Reichsmark or refused to lend to the government.
Was MEFO credible as a front organisation?
Upon the inception of MEFO, it was backed by $1 million Reichsmarks in capital from four large German manufacturers. These were Krupp, Rheinmetall, Siemens and Gutehoffnungshütte. On the surface, it was a private company, having genuine investments from leading firms. Moreover, it was not unreasonable for a company testing metal to buy military arms which contained said metals.
Of course, many realised the true nature of MEFO. It had no genuine sources of income, and its capital was insufficient to cover its vast purchases. But for governments, appearances and plausible deniability do matter. This is why private military contractors like Wagner exist.
As a thought experiment, suppose that the public saw through MEFO. Then the whole policy amounted to sending this unspoken message:
By using an elaborate legal scheme to hide our military spending, we acknowledge that it is a cause for economic concern. Indeed, in acknowledging it could cause economic concern, we demonstrate we are in touch with conventional economic principles. Rest assured that this duplicity shows we are a smart government, such that we have a clever plan to manage this debt.
Even if MEFO was not credible as a front organisation, it was credible as a signal that the government was concerned about being ‘economically responsible’. This assuagement of human psychology can be the difference between successful deficit spending that reinvigorates the economy, and unsuccessful deficit spending that triggers a currency crisis.
Why pay with a bill rather than cash?
As MEFO was merely a front organisation, it had no legitimate income. It had no cash to pay for anything. Therefore, it could only pay firms with promises to pay in the future (i.e. a bill). Recall that the initial backing capital was only $1 million Reichsmarks; this was inadequate to pay out all the bills issued to pay for military rearmament.
Why would companies accept MEFO bills as payment?
The MEFO bills were implicitly underwritten by the government, via the Reichsbank. Owners could exchange MEFO bills at the Reichsbank for cash at any time. For this privilege, Reichsbank would apply a discount on the bill. For example, a $1000 MEFO bill maturing in June 1935 might be paid $950 if the buyer demanded payment in February 1935.
Alternatively, owners of MEFO bills could wait until maturation, when MEFO would pay them back in full, rather than the Reichsbank. In our previous example, if the holder had waited until June 1935, they would have been paid $1000 with interest. Of course, MEFO had no money to meet these payments, so the money would ultimately come from government loans or bailouts.
Repayment of MEFO bills was undesirable for the German government, whether through discounts or maturation. Both required cash, the precise problem that MEFO bills were designed to avoid. Raising taxes was unpopular and would dampen demand. Borrowing or printing money would trigger a loss of public confidence.
How did the government avoid MEFO bills being converted into cash?
To avoid maturation, the MEFO bills were repeatedly extended. Recall that their maturation could be extended for 3-month periods. In the meantime, holders could satisfy themselves with the 4% interest payment, assured that they would be eventually repaid despite delays.
Discounting MEFO bills for cash was discouraged due to profit incentives. Suppose a firm spent $500 million and received $600 million in MEFO bills. A discount of 5% on those MEFO builds reduces revenues from $600 million to $570 million, a 30% loss in profit. The only situation where a firm would discount a MEFO bill was if it needed immediate access to cash, and had no other means.
There is another feature of the MEFO bill worth mentioning. Since the government guaranteed repayment, it was theoretically as good as cash. This would hold as long as the public maintained their faith in government finances. Importantly, this meant that firms could use MEFO bills to pay each other, as a type of currency, confident it was as good as cash. This greatly reduced the need for firms to convert MEFO bills into cash, as bills could be used in many daily transactions.
Did the public ever use MEFO bills as money?
MEFO bills only circulated within large firms because they were denominated in large sizes. As bills, they were not subdivisible. For example, a $100,000 MEFO bill could not be divided into one hundred $1000 bills. It had to be maintained as a single $100,000 bill, only suitable for large orders between firms.
Moreover, even if MEFO bills could be split, they would not be acceptable to employees as payment. Workers prefer cash, as it can be immediately used. A bill is unacceptable for everyday use because it needs to be taken to the bank before it can be converted into cash. Furthermore, it is subject to discounting. Workers would have to be paid extra after accounting for the discount. For example, $105 in bills for a $100 wage. This would cut into the profits of companies.
Importantly, the special circulation of the MEFO bill gave rise to a segregated economy between production and consumption. In the production economy, the MEFO bill became the dominant currency. In the consumption economy, cash became the dominant currency.
How did this happen? Heavy industry received payments in MEFO bills from arms companies or the government. However, it needed to spend cash on workers or purchases from small businesses, which would not accept MEFO bills. Workers and small businesses rarely bought heavy machinery, so their cash would not recirculate to heavy industry. From the perspective of heavy industry, MEFO bills would enter as income, but cash would leave as expenses. Therefore, there was a gradual leakage of cash from the production economy to the consumption economy. Large producers increasingly held their capital in MEFO bills, rather than cash. As such bills were as good as cash on paper, shareholders did not mind.
Let us use an example to demonstrate how the MEFO bill segregated the economy. Consider the heavy industry firm with $60 million in capital, all cash. It receives a $100 million order from an arms company for rolled steel, paid in MEFO bills. To produce that steel, it spends $40 million cash on wages, $40 million MEFO bills in machinery and materials from large firms, and $10 million cash in other purchases from small businesses. $60 million cash has changed into $10 million cash and $60 million MEFO bills. Company capital has increased by $10 million, reflecting profits. The cash has leaked into the hands of workers and small businesses, who spend it on personal consumption. This cash does not return to heavy industries, because consumers do not buy heavy machinery. Eventually, the MEFO bill becomes the dominant currency in the production economy, while cash remains king in the consumption economy.
Was the MEFO bill money printing?
Money is simply something which can be exchanged for goods and services. It does not necessarily need to be cash. The MEFO bill could function as money for payments between large firms. However, it could not function as money for consumers or small businesses.
MEFO bills were created whenever the German government bought arms. In this sense, they amounted to money printing, but with three caveats.
Firstly, MEFO bills only circulated within large firms. Money, in the form of cash, normally circulates the economy to boost the spending power of everyone. However, MEFO bills only circulated to boost the spending power of large firms to buy from each other. It did not directly increase the ability of everyday consumers to buy eggs and milk.
Secondly, blatant money printing is deleterious to economic confidence. The fiat nature of currency is laid bare, threatening a loss of faith in money. In severe circumstances, panic spirals into hyperinflation. The MEFO bill was designed to avoid this risk, through legal subterfuge. It was designed to avoid the loss of economic confidence that normally occurs with money printing.
Thirdly, the money embodied in MEFO bills was temporary. Whenever MEFO bills were discounted or matured, they would cease to exist, having been settled. At that moment, firms would no longer be able to use that MEFO bill to pay each other. The amount of ‘money’ that firms could use to buy goods from each other would prima facie decrease. This is in contrast to printing cash, which would circulate forever. The intuition is this: if the creation of MEFO bills increased money supply, then the retirement of MEFO bills, through their repayment, must decrease money supply.
What was the economic effect of MEFO bill repayment?
We previously claimed that MEFO bill repayment would decrease the money supply. It follows that MEFO bill repayment was deflationary. This is an unintuitive result. Therefore, we will use an example to illustrate how MEFO bill repayment is deflationary. It is helpful to have a pen and paper for following.
Suppose there are $10 billion in MEFO bills which will mature in 1939. This $10 billion functions as the chief money supply of the large industrial firms, in addition to $5 billion cash they retain for paying workers and small businesses. The producer economy has $15 billion in money supply. The consumer economy has a further $20 billion in cash and no MEFO bills. Total money supply is $35 billion, of which $25 billion is cash.
When the MEFO bills mature, the government has to acquire cash to pay them out. Suppose it does this through taxes on consumers. Then $10 billion is taken from consumers, reducing their money supply from $20 billion to $10 billion. This is a catastrophic hit to living standards. Firm money supply is maintained at $15 billion, now entirely in cash. Total money supply has decreased from $35 billion to $25 billion. The $10 billion loss in money supply corresponds to the retirement MEFO bills.
The situation is the same if the government acquired cash through borrowing. Once again, suppose that $10 billion is borrowed from consumers. The picture is entirely the same. Borrowing removes cash from those who have it, giving it to recipients of government spending, just like taxes. The difference is that the public has a government bond worth $10 billion. Loss of cash is compensated with a paper asset. Psychologically, they feel as rich as before. Nevertheless, the amount of money which can circulate to purchase goods and machinery has reduced, just as it did in the world of taxation.
In popular understanding, MEFO bills could avoid causing inflation as long as they were not converted into cash. The idea is that if MEFO bills were converted into cash, then their ‘quasi’ money printing nature would become full-blown money printing. However, the above analysis shows the contrary. Indeed, the repayment of MEFO bills through taxation or borrowing would have contracted the money supply, causing deflation.
There is a third way. Suppose that the government prints money to pay for the MEFO bill. Then while $10 billion in MEFO is lost as money supply, this is counterbalanced by $10 billion in newly printed cash. Total money supply remains unchanged at $35 billion, now entirely in cash. The economy remains exactly as it was, with one important caveat. While MEFO bills were limited to circulation within the production economy, the new cash threatens to leak into the consumer economy.
Notably, firms might use the cash to pay their shareholders large dividends. For years they have delayed these dividends to avoid discounting their MEFO bills. Alternatively, firms might have owed money to small businesses, having purchased on credit to preserve cash for wages. They now repay small businesses with cash. Shareholders and small business owners then use this cash to purchase goods, having lived frugally while awaiting their payments. A surge of money rushes into consumption, presenting a serious threat of inflation. While printing money to repay MEFO bills does not increase the money supply, it is inflationary because it allows money to be diverted from production to consumption.
Why wasn’t the MEFO bill inflationary?
There is a common perception that MEFO bills could avoid inflation as long as they were not converted into cash. It is based on the intuition that only cash, ‘proper money’, can create inflation. However, our above analysis has shown that this is not correct. MEFO bills would only be inflationary if they were paid through money printing. If they were paid through taxation or borrowing, they would have been deflationary at the moment of repayment.
From an inflationary perspective, the more interesting is not what happens when MEFO bills are repaid, but what happens when MEFO bills are created. If the creation of MEFO bills was money printing, why didn’t this have immediate inflationary effects? There are three reasons for this.
Firstly, the MEFO bill only circulated between large firms. What types of goods do firms buy from each other? Raw materials and expensive machinery. The latter increases real economic production in the long term, offsetting inflation. This is in contrast to putting money in the hands of consumers, which would immediately create inflation as they sought to buy goods. The difference is this: producer spending increases both GDP and real output, while consumer spending only increases GDP. The MEFO bill harnessed the former to offset inflation.
Secondly, the German economy was not at full employment. While increased production spending boosts long-term output, it causes short-term inflation. For example, if Germany wanted to build new steel furnaces, it would divert workers from building cars. In the short term, inflation would increase from fewer cars. In the long term, inflation would decrease from more steel. Thus, to avoid short-term inflation, increasing production requires more labour. If the economy had been at full employment, arms production would have drawn workers from other sectors, leading to shortages and inflation in consumer goods. Unemployment from the Great Depression supplied this labour.
Thirdly, the MEFO bill increased demand and supply in the same industries. The government increased demand for arms, just as the circulation of the MEFO bill improved the productivity of arms companies and heavy industry. If the government had printed money to pay for consumer spending, while encouraging investments in arms production, the mismatch would have created inflation. This is because consumers do not buy tanks. Of course, improvements in metallurgy to cheapen tanks also cheapen cars, but this effect is secondary.
What is the economic intuition behind the MEFO bill?
Following a depression, companies hoard cash because they perceive a lack of business opportunities. Decreased production spending leads to unemployment and poor wages. Poor wages lead to weak spending, perpetuating the lack of business opportunities. Productive capacity falls as machines rust from lack of use. The problem arises from insufficient circulation of money.
The MEFO bill alleviates this morass. By ensuring demand for production, companies spend again, giving cash to workers. Workers’ spending revives the consumer economy. Meanwhile, as the MEFO bill functions for interfirm payments, investment in acquiring machinery is increased. This increase in arms production matches the increased demand from the government, preventing inflation. By circulating money, the MEFO bill has increased supply and demand simultaneously, such that GDP increases without inflation.
The main limitation of the MEFO bill was that GDP growth was concentrated in arms production and heavy industry. The consumer economy, a better gauge of social well-being, grew by much less. Nevertheless, it is not difficult to translate war production into consumer production. This was highlighted in the extraordinary growth of the post-war era beginning in 1945. With certain adjustments, the German economy could better meet human needs in 1939 than in 1934.
Of course, nothing in economics is free. The MEFO bill forced large companies to invest in production improvements, paying with future promises. Although wealthy on paper, their shareholders had to live frugally since MEFO bills could not buy consumer goods. Viewed from this lens, the MEFO bill amounted to austerity on the capitalist class. Their spending power, embodied in cash, was transferred to workers via wages to revive the consumer economy. In return, they were compensated with paper wealth. Quietly, the rich company owners waited for the maturation of MEFO bills, such that their paper wealth could be translated into material wealth.
Did payment of the MEFO bills necessitate war in 1939?
Although extensions to MEFO bills could be added indefinitely, the guarantee of the Reichsbank was limited to 5 years. This effectively meant that bills would begin maturing in 1939, as further extensions were not credible without the continued guarantee of the Reichsbank.
As Hjalmar Schacht, engineer of the MEFO bill, argued in his defence at Nuremberg:
You see, I said very clearly that the limitation of the MEFO bills to 5 years, and making them mature in 5 years, would automatically put a brake on armament.
Schacht’s purposes were exculpatory. He suggested that by setting a 5-year limit on MEFO bills, German rearmament would have to stop by 1939. This was because the most economically conventional way of finding the cash was reducing defence spending. Schacht sought to minimise his role in German warmongering by highlighting this design.
The prosecutor, Justice Jackson of the US Supreme Court, sought to counter Schacht’s claims that the MEFO bill could have been resolved peacefully, through reduced arms spending:
MR. JUSTICE JACKSON: All I am asking you at the present moment, Dr. Schacht, is whether these bills could not have been paid out of the revenue from taxes.
SCHACHT: Surely. Yes.
MR. JUSTICE JACKSON: They could have?
SCHACHT: Of course, but that was the surprising thing, they were not repaid; the honey was used to continue rearming. May I add something in order to give you further information?
MR. JUSTICE JACKSON: No, I am really not concerned with the financing; I am merely concerned with what kind of a mess you were in at the time you resigned.
Although never explicit, Jackson’s incredulity points to another interpretation of the impact of the MEFO bill in 1939. As reducing military spending was contrary to Nazi policy, and further borrowing was no longer possible, this left a third option. This was to invade weaker European countries, using their gold reserves and assets to pay off MEFO bills. Such is the argument of historian Timothy Mason.
Of course, MEFO bill holders were not paid in gold, Polish paintings or Czechoslovakian machinery. Gold empowered the Reichsbank to print more Reichsmarks without losing public confidence, as it had more assets to support the currency. Meanwhile, looted assets could be auctioned off to Germans to raise cash to pay off MEFO bills. In this way, war welded the political ambitions of the Nazis with a solution to the economic crisis.
Mason’s argument is very compelling. Let us leave aside the question of whether Hitler considered the repayment of MEFO bills when deciding to invade Poland. From the perspective of economics, what is clear is that printing money was the only feasible way of paying off the MEFO bill. All other options, such as raising taxes, borrowing money, or reducing defence spending, would entail massive deflation due to the destruction of MEFO bills as a form of money. Only printing money would avoid this consequence.
As previously established, printing money posed substantial inflationary risks. In effect, the MEFO bill forced German capitalists to behave like hyper-producers, only able to use their money to mobilise more resources for production. Once they had access to cash, they could not wait to buy consumer goods. Therefore, in using money printing to avoid the deflation problem, one runs into an inflation problem from excess demand.
Increased demand can be counteracted by increased local supply. However, the German economy was already running at full employment, making further production impossible. Nevertheless, there is one creative possibility. The German government could have slashed its military spending, freeing up workers to work in the production of consumer goods, rather than heavy industry and weapons. This would have only partially mitigated inflationary pressures, as German machinery had been tooled to produce steel and tanks, not cars and yachts.
Increased demand can also be counteracted by increased foreign supply. Imports are one option, but that would quickly devalue the German currency, causing inflation. At this point, we arrive at the most straightforward option for a militarist state. It could use those arms to wage war on other nations, using loot to meet the excess demand from money printing. In this sense, the MEFO bill did make war inevitable.
What would a modern MEFO bill look like?
Suppose the German government used MEFO bills to buy consumer goods instead of arms. It could then store these goods instead of distributing them, boosting demand for local firms by acting as an additional consumer. This artificial demand would strengthen the consumer industry, similar to how it bolstered the arms industry. When it had to repay MEFO bills, the government could print money, converting the bills into cash. To counteract inflation, the stored goods would be released into the market. The inflationary risk of printing money to pay MEFO bills is perfectly managed.
An alternative to storing goods is to sell them abroad in foreign markets. The German government could have created a public company to buy and export consumer goods, accumulating foreign currency. To ensure exports were competitive, the company would be subsidised through government debt. When the time came to pay off this government debt, money could be printed, this time backed up by imports from accumulated foreign reserves. Discerning readers might note that this resembles the economic model of a certain country in the Far East.
What then is the magic trick behind these win-win situations? What are the core lessons of the MEFO bill for the modern day?
Money printing can stimulate the economy, provided it is carefully designed. Four criteria are necessary:
- Firstly, the government must obfuscate its policy through clever legal mechanisms or obscure economic regulations. It must publicly deny it is printing money, even though it is precisely what it is doing. This is to prevent public panic in the value of fiat currency.
- Secondly, the government must ensure that money printing finances the expansion of productive capacities, through investments in labour-saving machinery. This offsets the inflationary effects of printing money.
- Thirdly, the government must selectively enact interventionist policies to ensure that money printing finances the consumption of goods made by local firms. This ensures that money printing supports the revenues of local firms, rather than devaluing the local currency through increasing imports.
- Fourthly, where the economy is already at full employment, the government must increase labour supply to support production.
