Sunday, 14 October 2012

A Short Guide to 1920's Government Finance

In contemporary Hungary - severely affected by the financial crisis -, seeking foreign financing for government expenditures is not an easy business. With current yield rates for 10-year government bonds are around 7%, long-term market financing is not an option - yet the government is reluctant to seek help from the IMF, despite a debt to GDP rate of 74.6 percent in 2011.  Nonetheless, there have been multiple examples of the Hungarian government 'giving in to foreign pressure' - the most classical example is the one immediately after the First World War, which in the end lead to the establishment of the independent Hungarian central bank.

Népszövetségi Kölcsön [League of Nations Loan]
Source:  © IWM (Art.IWM PST 5759)


Following the First World War, the Hungarian economy was devastated. Having lost most of it's natural resources in the Treaty of Trianon, and further endangered by inner political turmoil following a communist and then a right-wing coup, the subsequent Hungarian governments had few tools to re-establish the economy. While monetary policy was largely independent and predictable before 1918 in the framework of the Austro-Hungarian Bank (based on the gold standard), the dissolution of it left the role of issuing money in the Hungarian government's hands. This, combined with the economic woes the country suffered from, provided a recipe for disaster.

Rebuilding efforts

Following the establishment of the Horthy era following 1920, the task of solving the jigsaw puzzle of Hungarian economic woes fell on finance minister Lóránt Hegedüs. His approach was one of austerity - he introduced the first ever general sales tax, the ÁFA, which is in effect to this day. However, his efforts at implementing a wealth tax - which would have been crucial in financing the Hungarian war reparations - have failed due to the fierce resistance of the wealthy land-owning class. Hegedüs resigned, and the only other option left to avoid bankruptcy was to seek help from the League of Nations, the precursor of today's United Nations and the only authority equipped with the power to lift the sanctions proposed by the victorious Allies on the sales of Hungarian government property.

Taking the loan

All contemporary actors knew that seeking help from the League of Nations would have it's price - but few realised the irony that by failing to abide to the wealth tax, the wealthier classes have brought upon themselves the exact fiscal prudence they wished to avoid.
The terms of the League of Nations loan were dire. France and Hungary's neighbours, victors of the war themselves wished that Hungary used the first part of the loan to finance reparations, and only the second part to re-establish budget balance. However, due to British pressure, the Allies finally made the loan's conditions more favourable, with the full amount reaching 250 million golden crowns, which the government accepted in 1924.


The deal consisted of two parts - the establishment of an independent Hungarian central bank, and the commissioning of an international officer whose sole responsibility was to enforce budget balancing efforts. The central bank, named Magyar Nemzeti Bank, (Hungarian National Bank), started out with a base reserve of 30 million golden crowns, and was designed to be completely independent from governmental influences - directly following the abdication of Lóránt Hegedüs, the government started to print money in order to finance the deficit, which caused the inflation to soar.
Historically less, but politically more important was the commissioning of the British banker Jeremiah Smith to monitor Hungarian economic policy for a period of 2.5 years, the deadline for re-establishing Hungarian budget balance as set by the League of Nations. His powers included the vetoing of economic decisions, mandatory consulting on all financial decisions beforehand, and even the power to propose new laws if deemed necessary for the sake of budget balance - not a bargain many would accept today, but a certainly efficient one.


In 30 months, the Hungarian economy has seen tremendous changes. Tax rates were increased, and by the end of the 1924/1925 fiscal year, the government budget has achieved a surplus. Hence, Jeremiah Smith allowed the rest of the loan to be spent as part of a fiscal stimulus programme - in the end, only 70 of the original 250 million were used as originally intended.
Meanwhile, the Hungarian central bank has stabilised the currency - when the aranykorona was switched to the pengő in 1927, it was more out of practicality than necessity (the usage of high denominations was inconvenient). Thus, the Hungarian economy was able to experience a period of relative growth until the onset of the 1929 financial crisis - but that is another story.

Sources: Múlt-Kor, Történelem Portál, Origo (All in Hungarian)

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