History of Economics and the Economy V - The end of globalization - PDF

History of Economics and the Economy V: The end of globalization: World Wars and the Great Depression Contents of this chapter 1. Description: The interwar period in long-run context 2. The impact of the first world war on economy and society 3. Postwar stabilization measures 4. Th...

History of Economics and the Economy V: The end of globalization: World Wars and the Great Depression Contents of this chapter 1. Description: The interwar period in long-run context 2. The impact of the first world war on economy and society 3. Postwar stabilization measures 4. The rise of the US as new economic leader 5. How a recession turned into the Great Depression 6. Why a recession turned into the Great Depression: gold standard and dysfunctional monetary policy caused unemployment, demand and production to collapse 7. How countries got out of the Great Depression by leaving the gold standard and allowing prices to rise again 8. Summary: causes of the Great Depression 9. Bibliography Anatomy of 30 years of crisis, 1914-45 Description of a sequence of crises Impact of the First World War (1914-18) on the international economy further issues caused by the Influenza pandemic 1918-20 Hyperinflation and stabilization after 1918 in much of Europe Crisis (and deflation) after 1929 Why did the Great Depression happen so shortly after recovery? How was/could such a crisis be overcome? Common question in the background: How are the aims to reconstruct the pre-1913 world at the beginning of the 1920s linked to the Great Depression (and overcoming it) after 1929? Key questions 1. Why did 19th Century market integration collapse? 2. How do you finance a war? How do you get back to normal? 3. How to return to a stable postwar economy? 4. What did go wrong in the 1930s? 1 1. Description: The interwar period in long run context The end of globalization and thirty years of crisis, 1914/18 to 1945/50 (import and) export to GDP ratios – the end of the first globalization (see script 4, p. 1) https://ourworldindata.org/grapher/globalization-over-5- Source: Federico and Tena-Junguito (2017), centuries-km , probably also used in Crespo/Essletzbichler http://hdl.handle.net/10016/22355 World trade broke down during the First World War (not even measured here, gaps in time series) and again during the Great Depression and then again in the Second World War. The breakdown of international finance (left) and rise of trade protectionism (right) Average tariff rates (taxes on imports), percent of import value, 1900-2000 Source: Obstfeld and Taylor (2004), p. 127. Source: Tariff revenue as percent of import value, data from Lampe/Sharp (2013) International finance and the gold standard collapsed during the First World War, were (shakily) reconstructed and collapsed again after 1929. Similarly, in the 1920s, and especially the 1930s, barriers to trade increased to very high levels. After Second World War, trade was soon liberalized again, especially in Europe and the US (not necessarily in ‘peripheral’ countries in the World Economy like India or Argentina, and surely not in the Communist World), but the Bretton Woods system allowed for only reduced reintegration of financial markets until the 1980s (class 6). The boom in global market reintegration probably starts around 1970s as well in the graphs above (this might have to do with the rapid increase in oil prices that suddenly made up a large share of GDPs in ‘Western’ oil importing countries). 2 The end of macroeconomic stability Based on data underlying Reinhart and Rogoff (2009), Fig 12.1 (link). Source: Reinhart and Rogoff (2009), p. 74 (link). While inflation rates were globally stable and fluctuated around 0-2 percent before the First World War, the period after 1918 saw a back and forth between high inflation and pronounced deflation (falling prices) in a short period of time. The 70-country median on the left side, shows a typical, not the most extreme examples. The right panel indicated a globally unprecedented incidence of banking crises after 1930 (in a period when, for example, deposit insurance did not exist in most developed countries). Return to average annual growth rates almost like before 1820 (in Western Europe) 3 Increased government participation in the economy (First World War) Source: Broadberry and Harrison (2005) The major belligerent countries (UK, Germany, France) spent about a third to half of their GDP every year on the war effort – even more in 1917 –, and this does not even include the costs from destruction of infrastructure and material produced before the war. Parties like Austria-Hungary or the Ottoman Empire only managed to spend c. 30% of their GDP because they were unable to ‘extract’ more from their economies, due to them being poorer and state capacity (also for taxation) being lower. The US, etc., did not have to spend so much. Even in a country that after the war was highly cash-strapped like Germany, postwar government involvement in the economy was roughly twice as high as before the war (and increased again to unsustainable levels during the Second World War). Taxation in Germany, 1913/1924-1942: increasing after 1918 and during WW2 (extreme example) Some additional taxes (some sales tax, tax on sparkling wines, etc.) were added. Source: Spoerer (2015/2017) 4 2.The impact of the first world war on society and economy Social and economic costs Impact of First World War on economy and society The war killed people, destroyed human capital: 33 bellingerent nations, with a population of 1.100 mio (61% of world pop), of which 70 mio mobilized (4% world pop), 20 mio. wounded, 15 mio. disabled; 20 mio. excess deaths (10 mio soldiers, 10 mio civilians). Most affected: Russian and German Empires with ~2 mio lost soldiers, in Ottoman Empire about 2.5 mio civilians died in excess of normal; in relative terms, Serbia, Romania and Ottoman Empire lost most lives (>22%, c. 8%, c. 14% of prewar population). The cost in expenses and destruction was estimated at 416,000 mio. dollars in 1938 prices (which would be about 7,550,000 million dollars today). For lost human capital (education of war deaths), shipping and cargo loss and property loss as well as forgone production, etc., another 258,000 mio. 1938 dollars (4,680,000 mio. dollars today) are estimated. World GDP in 1900 was approximately 4,000,000 mio in today’s dollars. So World War I directly cost roughly 2 years of world production and another year in human capital losses and forgone production, etc. This is a rough estimate which relies on a lot of assumptions Is it plausible? See p. 4: some of the largest economies in the world spent about half of their incomes/production on the war for several years So, the war hugely increased the share of the government in the economy during the war and after it. The (unprepared) way in which this happened created problems of internal and external government debt, which persisted through the settlement of the peace (reparations and the political conflicts that arose over war debts). The war disrupted international markets through direct war action and by political regulation, and these disruptions created (like with the Corn Laws during the Napoleonic Wars 100 years before) domestic producers who after the war demanded protection and shelter from international competition. The peace also created new (or reestablished preexisting) countries (Poland, Czechoslovakia, …) that often increased taxes and trade barriers (also for revenue purposes), so additional borders disrupted former division of labour. The attempts of “going back to normal” (to before 1914 conditions) created an environment that overshot on fighting inflation and did not manage to stabilize economies in the long run. Eventually, this gave us, for example, modern macroeconomics. Political processes were a big part of the story, too, but we cannot go deeply into them in this class. Brief remark: especially in countries where autocratic regimes lost confidence during the war (e.g., in Germany, Austria, Hungary, Russia, etc.) the war triggered a wave of regime changes that led to (often unstable) democracies and the surge of socialism in the former Russian Empire. Also in countries with parliamentary democracies before 1930 (e.g., US, UK, France, Belgium, …) the franchise was extended, e.g. to women and poor(er) men, because of their efforts or suffering during the war. This led to new political constellations, less grip of traditional aristocratic and bourgeoise elites on power (although their power was not universally revoked), the rise of new parties on the left and right, and with this, new, often unstable policy constellations in times of significant political, social and economic challenges (pp. 1-3). 5 A note on the Spanish flu Between February 1918 and April 1920 it affected some 500 million people, and killed between 17 and 50 million, most in poor countries (e.g., India) with low medical and statistical capacity. Barro et al (2020) estimate 40 mio deaths in 48 countries with data (2.1 percent of world population). GDP would have declined by about 6-8 percent per year in 1918-20 due to the flu (controlling for the effects of the first world war) In general, in 1918-20, pandemic induced recessions in (richer) countries with better data were not very long and relatively mild (see Denmark and US) Cities with (brief and incomplete) lockdown measures did not fare higher costs (so, no identifiable tradeoff between saving lives and saving the economy, see the US paper linked in the preceding bullet point) Lockdowns were much less preventive than in 2020-21 when the number of deaths (for a different disease, of course) was lower, due to better and much more available medical services and preventive lockdowns that crushed the first wave in many places. WWI especially in the French war sites seems to have facilitated spread, as did press censorship during war. Long-run impact on economy and society are (still) underresearched and probably mixed with impact of WWI, although there has been a wave of research during the Covid-19 lockdowns: Governments built up epidemiological regulations, some also fortified health services and social protection Potential inward turn from WWI reinforced by need to raise revenues for such services (see here) Potential negative effect on ‘trust’ and social capital among the survivors (Aassve et al 2020) War finance, postwar reconstruction and their economic impact War finance and the economy: No prior experience with warfare at this scale → no established mechanisms for financing multiple-year multiple-front wars. During 19th Century the role of the state in the economy and tax burdens had been relatively small Options: increase government revenues (higher taxes): this has limits, since it requires administrative and bureaucratic state capacity to raise and increase taxes in a much more comprehensive way; many governments were lacking capacity, and societies have a limit to tolerable tax burdens, even in times of war. internal public debt (borrow from your population) external public debt (borrow from other governments and populations, see p. 8/9 on interallied war debt chain) print money and pay with it (causes inflation, gold standard will have to be – and was – abandoned) War finance eventually creates several problems 6 Governments could not pay back their debt to their own population unless the war turned out “profitable” or economies returned to pre-war activity levels with significantly increased taxation after the war (remember Ricardian equivalence from Sandmo, ch. 4). Paying back debt to other countries requires a balance of payment (often: export) surplus (inflow of funds from abroad), especially if debt is denominated in gold-backed currencies. Creates incentives for protectionism with corresponding negative consequences on the countries that the debt is paid to (and problems if these countries themselves protected). Keynes called this the transfer problem (especially, but not only, in the context of German reparations). Disruptions and money printing increased the price level, and in many countries in the postwar time money-printing continues to finance reconversion. This causes inflation, which conveniently devalues domestic debt if govements decree the unstable postwar currency to be equivalent to the stable currency in which debt was contracted (thus effectively expropriating bondholders). Discussions about reparations make peace fragile and cooperation in reestablishing prewar institutions and equilibria difficult, due to the protectionist and ‘blame the others’ incentives inherent in most of the points above. Example of inflation during and after the war: Austria, 1913-24 Source: Jobst/Kernbauer (2016) Germany in/after hyperinflation 1923 In Germany, there were notes of 200,000,000,000 mark in circulation that were not enough to pay a taxi; in the end, a loaf of bread cost 105,000,000,000 and a liter of milk 26,000,000,000 mark. Source: http://einestages.spiegel.de/static/topicalbumbackground/4632/als_die_mark_vernichtet_wurde.html 7 Broader perspective: Price level in 1914=100, and their rise Austrian and German currency lost more than 99% of its value in comparison to 1914 (or even 1918, the end of the war). French and Italian currency ‘only’ lost 85%, US, UK and Switzerland only 40-50 percent. This meant, of course, that exchange rates became radically different (see Dollar price in Vienna on p. 7), unstable and difficult to predict. It also affected the value of assets owned in foreign countries, etc., depending on whether these were valued in gold currencies before 1914 or paper/nominal currencies after 1918 (more on this below). External debt How much debt did the allied forces incur? The US entered the war in 1917 only. Before, the Allied powers purchased arms, food, etc. that they needed beyond their own ability to produce in the US via commercial loans (from American banks), by paying with their gold and foreign exchange reserves and in other ways. When the US entered the war, it launched its own war bonds and did not want other (allied) countries to compete for access to US national savings, so Congress made a law, the Liberty Loan Acts, that allowed to earmark a part of the Liberty Bond proceeds to go to allied countries' governments, a total of 10,000,000,000 dollars. See here for more: "The Secretary of the Treasury was instructed to enter into arrangements for the establishment of such credit, for the purchasing of obligations of the foreign governments, and for the subsequent payment thereof before maturity. It was also authorized that the money made available through payments on these obligations be used for the retirement of outstanding Liberty Bonds.” So, in 1918, the Allies had debt with American banks as well as with the US government, who planned to use the proceeds from repayment by the other Allies to repay the Liberty loans (and thus did not want to forgive the war debt to enable the Allies to forgive reparations). All allies were indebted with the United States (their government in turn did not owe to anyone, except its own population). Germany, Austria and their confederates of course did not have access to the US capital market during the war, which is why their debts were mostly domestic. 8 Great Britain was only indebted with the US, but France and others were indebted with the United Kingdom (and the US), because the UK had borrowed money to them. Others (e.g., Italy) were also indebted to France. This created an inter-allied debt chain (in US$ mio.) Source: Kindleberger (1986), Graph from a presentation by Ulrich Pfister (University of Münster) To repay these debts and finance reconstruction and repayment of domestic loans, all of the winners of the war needed money (especially France, Belgium, Italy) and wanted the losers to pay for their damage – “reparations”. This had been standard practice in prior wars, e.g., after the Napoleonic Wars or the Franco-Prussian War of 1870/71. Just now everything was on a much larger scale because of the much larger scale of the war. There was also a desire for vengeance (in France, due to massive reparation payments to Germany after a lost war in 1870/71). These countries demanded that Germany and its allies should pay all the damage. Eventually, Austria, Hungary, Turkey and Bulgaria saw initial reparation demands reduced substantially or cancelled after some payments in 1922/23 and the reparation debate centered around Germany. Problem: Reparations might suffocate new German government and economy and lead to social chaos What can be done? Two positions in the discussions in Paris that led to Treaty of Versailles: France and the UK – tried to connect the reparations with their international debts (so the reparations would cancel the debts, or a renegotiation of the debts would lead to lower reparation needs) US: we cannot suffocate Germany, but the commercial credits given to other countries by American banks and public have to be paid back (no connection between debt and reparations) Eventually, Germany is obliged by the Treaty of Versailles to pay 132,000 mio. “gold marks” (that is gold equivalents at the 1913 rate, this was equivalent to 33,000 mio US dollars in 1919) of reparations to the allies, in three “modalities”: A-bonds (indemnity, 12,000 mio), B-bonds (more or less as high as interallied war debt, 38,000 mio.) and C-bonds (82,000 mio., a ‘political bargaining chip’). A-bonds were roughly 20% of German 1913 GDP, A+B 100% and A+B+C some 260% (Ritschl 2012). Germany did not pay (only one complete annual payment until 1922); France and Belgium occupied the Ruhr area (the heart of German heavy industry) to force payment in January 1923. In response, Germany declared a general strike in the occupied area (and paid the workers with additionally printed 9 money). This accelerated (more money in circulation, less production to be bought) the ultimate destabilization of the German economy into a hyperinflation (1923) In the end, Germany “restabilizes” in November 1923 and the Allied forces resume negotiations about reparation payments, which leads to the Dawes Plan (1924): Germany pays annually, but not in gold and gets help with (private) credits from the US. Young Plan (1929): The amount of reparations is reduced to $26,350 million and the period of payment is prolonged to 58.5 years (until 1988). Already in 1931, the Hoover Moratorium temporarily suspended reparation payments, and in 1932 the Lausanne Conference declared the end of German reparations against a final payment (which never became effective). This whole discussion about reparations, war debts and their payment had negative effects on international financial markets and the cooperation between national central banks (which had been a cornerstone of the pre-WWI gold standard). This meant that international investors were less inclined to facilitate credit in times when many governments (and firms) needed to borrow for reconstruction, adjustment, etc., and lending became more short-term, financial markets more easily destabilized 3. Postwar stabilization measures Gold standard and goal of returning to prewar institutions: How to stabilize after inflation? Use (return to) the Gold Standard! With all the destabilization in international markets and the problem of inflation and hyperinflation in national economies, countries wanted to return to stable economic conditions. They aimed to achieve this by going back to the pre-1914 gold standard which had been suspended during the war. Under the gold standard, the value of different currencies was fixed in units of gold, which in principle creates price stability. Furthermore (see class 4) this would hopefully induce stable government finance and stable, trustworthy environment for investment. In principle, if all countries fix their currencies to gold (reserves in the central bank), an automatic fixed exchange rate regime emerges with the relative official price of gold between different currencies (mint parity) as equilibrium exchange rate – as long as gold can be freely traded. This means that price and interest levels in all participating countries will have to move together, since a price increase will lead to an increase in imports, but not in exports (relatively cheaper foreign goods, relatively more expensive domestic goods)– this trade deficit means foreigners will now have more home country currency in their hands than home country actors have foreign country cash. This would under flexible exchange rates lead to a devaluation in the price (exchange rate) of the domestic currency. Under the gold standard, this is ruled out (beyond a small band determined by the transaction costs of trading gold internationally), instead foreigners will exchange home country currency for gold, take the gold abroad and exchange it there for their currency. This outflow of gold reduces central bank reserves and the credibility of the commitment to convert circulating (paper) money into gold (the same is more or less true for interest rates that are too low, then capital will flow out). Governments and note banks therefore must do everything to maintain the domestic price level stable (which is what they had large problems with after WWI and what they did not want to happen again). And since central banks and governments had printed money to help the war effort and stabilization, they needed to sustain trust in their renewed commitment to price stability (and not violating the rules) with more emphasis. One way governments might violate this rule would be to ask the central 10 bank to print money beyond what its gold reserves allow to buy government bonds with this (so called ‘fiscal dominance’ of the Finance Ministry over the Central Bank). How the gold standard worked (in principle) International gold standard: Mechanism For this see the background reading by Eichengreen, pp. 25-30 (see background readings in Canvas) for a description Background: Equation of exchange (‘Fisher equation’): M ·v = Yr ·P M= amount of money in circulation (not just cash, also demand deposits), v = velocity of circulation, Yr = real value of national income/expenditure, P = price level Scenario 1: Inflation in one country (specie-flow model, David Hume 1755) Scenario 2: Central banks and interest rates (Cunliffe Committee, 1919) Scenario 2a: Interest rates and capital flows 11 In principle, the Gold standard is thus a self-stabilizing mechanism (Hume), in which central banks can accelerate/preventively aid the adjustment with monetary policy (Cunliffe Committee). The central bank itself, however, cannot take other monetary measures than those that help to adjust the price/interest level to international conditions. In practice this was more or less the case until 1914, although confidence in and commitment to the system assisted this self-stabilization: Central banks might not be too interested in increasing interest rates too much, since this might depress the economy - limit credit and discourage economic activity (trade in the case of bills of exchange or investments in general (and they also made government debt more expensive!) [→ Foundations of Macroeconomics]. As long as most people believe in the long-run stability of the gold standard, investors will buy a currency when it is in danger of becoming too cheap, since they know it will not become too cheap (see next slide) but can benefit if it becomes more expensive again. Therefore, in times and places of trust (‘core’ pre-WWI) legal gold cover ratios (gold/money) could be suspended/violated for short time spans, given the general confidence in the system. Furthermore, in moments of crisis (like the Baring crises, when the Bank of England used its reserves to stabilize the Baring Bank and prevent a collapse of the banking system), the central banks helped each other (transferring gold reserves, e.g., in the Baring crisis the Bank of England received backing from the Russian central bank; or by coordinating interest rate policy) However, such trust in the system was much more easily maintained by central players with well- established reputations than by peripheral countries that were still acquiring reputations and the seal of good housekeeping (see week 4), and thus would be subject to less ‘self-stabilizing’ and more ‘self- defeating’ speculation. Note: Positive deviation from mint parity means lower exchange rate, the currency is “cheap” and will be “more expensive” once mint parity is reached again. After 1918 more countries were in the position of “untrusted periphery” Source: taken from a presentation by Matthias Morys (then Oxford, now York University). 12 The problem in the interwar period was that because of the inflationary experiences and the instability in exchange rates during and after the war (pp. 7-8), most of the former ‘core’ countries (with the notable exception of non-belligerent countries, especially Switzerland) were now in the situation that ‘peripheral’ countries had experienced before 1914. The trust in their currencies and in the commitment of their governments and central banks to price stability and the gold standard was much reduced. Which is why they needed to play much more tightly by the rules and create trust in their commitment. This involved applying the standard recipes against inflation and suspicion of lurking fiscal dominance: Tight monetary policy whenever there is a sign of balance of payment deficit (to induce deflation): high interest rates (with potential effects on credit, investments and employment in the economy) Assure everyone that the government will not use the central bank to print money or buy excessive government debt, cause (hyper)inflation and abandon the gold standard Independent central banks (no government influence) who will implement monetary policy ‘no matter what’ Balanced government budgets to fight the fear of fiscal dominance (avoid need for ‘printing money’): budget cuts if government income is decreasing; tax increases if spending side is increasing So, to control inflation, the cost might be less credit to economies, less investment and lower employment and thereby monetary or fiscal policy cannot be used to combat crises if these crises go along with balance of payments deficits (as they often do) you can go through the IS-LM model from Foundations in Macroeconomics what it means if monetary and fiscal policy in crises are not available – note that the IS-LM model (and macroeconomics) was not ‘invented’ yet by the 1920s (it is based on Hicks’ Mr. Keynes’ and the “classics” from 1937). Further issues in the real world of the 1920s and 1930s The return to gold after the war was disorganized: In 1925, Britain returned to the prewar gold value, despite inflation and especially higher inflation than in countries that continued on the gold standard (US, Switzerland, see p. 8). This preserved the value of British foreign investments (for capitalists), but required internal deflation to maintain export competitiveness. Deflation, however – especially with not fully flexible wages and interest payments – likely causes profit squeeze, industrial unemployment, wage cuts, and therefore has negative consequences for the ‘real’ economy. Other countries, like France and Italy, changed the value of gold in their currencies in a more favourable way for export competitiveness by devaluating their currencies against gold by more than the inflation differential (visible on p. 8). This meant that they partly expropriated their capitalists, but created an exchange rate that put their producers at an advantage in relation to the UK, for exports were now ‘structurally’ cheaper. This was augmented by an asymmetry in the need to react to imbalances: The country/central bank faced with gold outflows (here: UK) had to react (by increasing interest rates in the Cunliffe Committee model), but the ‘receiving’ country (France, Italy) did not have to do the opposite (lower interest rates or increase the amount of money in circulation). It can decide to “hoard” the gold (and to appear more solid) and not extend its monetary supply. This is called “sterilization” – this means automatic balancing only works half-way, as prices in the country with the balance of payment surplus will not necessarily increase. Given the experiences with hyperinflation, after the war even for ‘core’ countries credibility was more difficult to achieve, and hence speculation was more likely to move against ‘automatic stabilization’ and more towards ‘we don’t trust this currency’ – this again required stronger central bank reactions. 13 Also, with all the international frictions due to war, reparations, war debts, asymmetric return to the gold standard, cooperation between central banks was much more difficult after 1918 than before. Finally, because of new general suffrage and strengthened position of trade unions, the political willingness/scope for internal adjustment (deflation accompanied by nominal wage decreases) declined, leading to constant tension between stricter handling of adjustments and stronger sensitivity for the economic effects of adjustments. The main problem with the interwar gold standard: once fixed, exchange rates are ‘forever’ Parity=the price of gold in terms of the currency (i.e., the basis of the gold standard), “% of that before WWI” indicates whether it was the same parity as in 1913) Every country chose to enter when convenient Every country chose its own parity, some “overvalued” (not compensating for inflation relative to USD or gold) – like UK or Sweden, some “undervalued” (like France or Italy) The interwar gold standard only worked effectively between July, 1926 (when the French Franc entered) and September 1931 (when the British Pound left it) – little time to rebuild trust. Parities divided by the price level relative to the US at the moment of return to Gold Standard (table above in comparison to table on p. 8). For Germany and Austria, the formal parities lost all their meaning in the hyperinflations of 1922 and 1923. French (and Italian) currencies were ‘undervalued’. With these data the stabilization of the British Pound at the same rate of 1913 seems reasonable, but the relative price level in 1926 was the result of deflationary politics since 1921/22 (that were accompanied by strong recessions). Consequences: “The interwar gold standard, resurrected in the second half of the 1920s, consequently shared few of the merits of its prewar predecessor. With labour and commodity markets lacking their traditional flexibility, the new system could not easily accommodate shocks. With governments lacking insulation from pressure to stimulate growth and employment, the new regime lacked credibility. When the system was disturbed, financial capital that had once flowed in stabilizing directions took flight, transforming a limited disturbance into economic and political crisis.” Eichengreen (1995/2008, p. 46) 14 4. The rise of the US as new economic leader Economic boom in the US in 1920s The United States were experiencing an economic boom (Roaring Twenties) continuing process of capital- and resource-intensive mechanization in industry, but also in agriculture (tractors) generalization in the use of electricity in factories spread of Taylorism (‘scientific management’) development of new electricity-driven consumer goods (refrigerators, etc.) extension of consumer credit makes mass consumption possible generalization of modern marketing and distribution technologies This went along with optimism initially unmatched in Europe, but transferred there after stabilization around 1924 Ford Model T assembly line in Detroit, introduced in 1913 – price falls from $525 to $260(1925) – increased then with model updates. Picture taken from this website. The US became a central capital provider for stabilizing Europe In the First World War and all the discussions around reparations and German stabilization (Dawes Plan), the US became a major creditor to European countries, and European stabilization depended on US credit US lend to Germany Germany paid their reparations to the Allies These paid their war debts to the US And US loans to Europe went much beyond the Dawes Plan, as European countries were in need of funds after the war. So, everything depended on financing of the German government by private US investors, and most of the credits from the US to Germany were short-term loans/bonds What if these private investors find more profitable investments elsewhere? 15 The stock market boom, the stock market crash and international stability The New York Stock Exchange: Three-month-period index (Jan-Mar 1920=100) of the Dow Jones, and dividends paid by the joint-stock companies included in the Dow Jones index, 1920-30 Source: White (1990), p. 154. Stock markets In New York, and, less pronounced, in London stock prices increased from 1926. In New York, the stock prices increased until 1928 in line with the evolution of dividends (‘reasonable’). Since 1928, it seems that there was a non-rational bubble evolving. Possibly, the Fed’s low interest policy contributed to the increase in (credit-financed) purchases of shares; this was in part a side-effect of the Fed’s attempt to help Britain to go back on gold standard at old parity/gold price (as a rare example of a country that lowered exchange rates to help another country to balance its balance of payments). The stock market boom also diverted US investments away from Europe. This caused troubles in Germany (and its debtees/creditors), as Germany (private firms and public entities) were scrambling to refinance the drying up of funds form the US. From October 1929, stock prices decreased dramatically at the NYSE and the expectations of investors subsequently changed. This was in part because of an increase in the Fed’s interest rates, in part because of a deceleration of growth in the “real economy” (a cyclical recession, starting with a temporal closure of a major Ford factory to rearrange assembly lines). There was also uncertainty about what the stock market crash meant. Listen, for example, to the eminent economist (and then financial advisor) Irving Fisher, on 23 October 2023: https://www.youtube.com/watch?v=MEc7sE7psJA. (Fisher lost a large part of his fortune and reputation in the crash.) In the following, we will see that the stock market crash led to the Great Depression only with a delay of more than a year because the links between financial markets and the real economy are not as direct as it may seem. 16 5. How a recession turned into the Great Depression Outline Great Depression “Monetary” economy October 1929ff. Stock market crash (first in New York) Deflation 1925/29-1932, especially in agricultural and other primary products already since 1925 Banking crisis 1931–1933 Many countries are unable to meet their public debt (default), 1931/33 “Real” economy Industrial production falls 1929–1932 Crisis of agriculture in many countries (contributes to banking and public debt crises) Employment falls 1929–1932 World Trade falls 1929–1932 Institutional level Gold standard is abandoned in UK 1931, US 1933, France 1936 Protectionism: Increases in tariff rates, bilateral exchange agreements (to balance the balance of payments not according to market outcomes, but after political negotiations) Falling Prices/Deflation Prices and inventory stocks for wheat and raw cotton, 1920–1938 (1929=100) Baumwollpreis=Price of raw cotton, Weizenpreis=price of wheat, Lagerbestand=inventory stocks Source: Kindleberger (1986). From a presentation by Ulrich Pfister (University of Münster) With the return to ‘normal’ conditions in the world economy, prices come under stress, as in many countries during the war production capacities had been increased (not only in wheat and cotton, also in the heavy war-oriented industry). This led to structural overproduction and thus rise in inventories already from the mid-1920s. Falling prices were the consequence since around 1926 already. This squeezed the incomes and profits of agricultural producers and affected (a) farmers’ ability to finance debt in many places, which had increased because of war-supply related investments and (b) government 17 revenue in ‘peripheral’ countries were export-oriented agriculture was the major economic activity (see class 4). The problem of debt deflation and banking crises The banking crisis starts with defaults of many small and a few larger banks in the US (from 1930, accelerating in 1931). Falling prices after 1929 also affect banks with large industrial assets in Austria (Bodencreditanstalt, and then Rothschildt’s Credit-Anstalt & Steyr Werke), Germany (DaNat-Bank & Nordwolle), etc. Explanation: debt deflation Cyclical crisis (overproduction and demand slump) leads to lower prices (see p. 17). This increases the burden of (nominal) debt in fixed instalments, while incomes/revenues and profits are squeezed between falling prices and sticky (nominal) wages increases rate of non-paid outstanding credits that banks have given to private entities these credits in the US were mainly based on short-term deposits; once the depositors started to fear that banks would be unable to return their deposits, they ‘run to the bank’ and claim these deposits, leading to the banks’ effective illiquidity and insolvency in Europe, credits were either backed by participation in struggling industrial firms (which suffered in demand slump and for other reasons) or by loans from abroad (US) which were called back for speculation (first) and to save banks there (later) Spread to national governments – especially those of primary product exporters who were hit hard by falling prices – government defaults partially independent effects came from ‘foundation booms’, subsequent stabilization and consolidation and unsure (and risky, speculative) lending policies of banks as a consequence of inflation in some European countries and the following stabilization capital inflows (Austria and Germany were central cases) Banking crises in 70 countries, 1900-2008 (percent of countries having one) 45 40 35 30 25 Percent of counties 20 15 10 5 0 19001910192019301940195019601970198019902000 18 6. Why a recession turned into the Great Depression: gold standard and dysfunctional monetary policy caused unemployment, demand and production to collapse Why? The Golden Straitjacket of the Gold Standard The banking problems could have been solved, but this endangered the “secret against inflation and distrust” underlying the (interwar) gold standard outlined on p. 12. On the banking side, extending credit/liquidity to banks (or governments) might have undermined the credibility of the central bank to maintain the currency backed by gold reserves. This was exacerbated by the spread of distrust in all countries, as banks were calling in loans from abroad to survive, thereby endangering currency reserves of foreign banks and central banks On the fiscal policy side, using government money to create transfers or employment for the unemployed or orders for firms would endanger the soundness of the budget and hence the fears that governments would turn to central banks. This was especially problematic since the recession decreased government tax revenues. Instead, many governments used protectionist policies to help domestic enterprises (but this did not work our as foreign governments did the same and effectively transferred the demand slump by imposing barriers on exports). So, instead of saving banks and maintaining economic activity, governments tried to balance budgets (by cutting expenses in view of falling tax receipts) and central banks “sterilized” gold reserve to strengthen confidence in their “solidity”. How this deepened and internationally spread the crisis is explained in a short simple video starring Milton Friedman on the Gold Standard, taken from episode 3 of his television documentary series Free to choose (PBC, 1980), (https://www.youtube.com/watch?v=O7pnjzCuSv8)1. In the video he attributes the lack of expansionary monetary policy as a mistake to the US Federal Reserve (that should have injected money into the economy by buying Treasury bills). However, this decline in the amount of money and the sterilization of gold reserves was a general reaction all around the world due to the logic of the gold standard. As can be seen on p. 20, countries on the gold standard saw prices fall by more than 20 percent between 1929 and 1931, a major deflationary episode. Spain, a country that had planned to (re)join the gold standard but failed to accumulate enough gold, did not see any falling prices after 1929, although in part it was affected by what happened abroad (see below). Abandoning the gold standard in 1931, as Britain, Scandinavian countries and other countries did, stopped falling prices, while prices continued to fall in France, the Switzerland, the Netherlands or Poland, that stayed on the Gold standard. The US left the gold standard in 1933 under President Roosevelt, and economic historians and economists (including Friedman) generally agree that this helped recovery more than the New Deal. 1 For the full episode see for example https://www.youtube.com/watch?v=jOO4kPSaD4Y – no endorsement of the Youtube channel involved! The central piece is from about minute 18:35 to minute 20:53. 19 Gold standard and deflationary pressures (1929=100) 120 100 80 60 Spain 40 Countries that abandoned the Gold Standard in 1931 (average) 20 Countries that abandoned the Gold Standard in 1936 (average) 0 1929 1930 1931 1932 1933 1934 1935 1936 Source: Bernanke and James (1991), p. 43; Graph from a presentation by Ulrich Pfister (Münster) No gold standard in Spain in this period. New York Times, 20 April 1933. 20 Consequences: Industrial production index (1929=100) 120 100 80 60 Germany 40 France UK 20 Spain US 0 1929 1930 1931 1932 1933 1934 1935 1936 Source: data from Bernanke and James (1991), p. 45. From a presentation by Ulrich Pfister (Münster) Industrial production fell considerably more in 1929-31 in countries on the gold standard than in Spain (although Spain was then affected by crisis and protectionism abroad and its own unstable political climate), and in the UK recovery was much earlier and faster than in France, Germany or the US, which left the Gold standard in 1936 (France), 1933 (US, and Germany effectively by imposing capital controls and manipulating exchange rates). The effect on unemployment was similar, much lower in the UK than in the US or Germany. The French experience is a bit weird at first sight, and in part has to do with the enormous gold reserves accumulated before that allowed less strict initial reaction (but would not have been generalizable as a crisis-fighting policy), and in part with the structure of French industry. In the end, the crisis, nevertheless was longer and cumulatively worse in France than in most other places. Industrial unemployment, 1920–1939 (%) 50 Germany 45 Unemployment rate (%) France 40 35 UK 30 US 25 20 15 10 5 0 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 Source: data from Eichengreen and Hatton (1988), p. 6. Graph from a presentation by Ulrich Pfister (Münster) 21 7. How countries got out of the Great Depression by leaving the gold standard and allowing prices to rise again Politics to solve the crisis No international cooperation (some fruitless conferences were held). The world economy disintegrated into “currency and trade blocks” often held together by bilateral agreements instead of open markets: “Sterling block” of 1931 gold standard leavers and devaluators around UK (but evading appreciation after 1931, “dirty floating”) German (“Nazi”) block (South-Eastern Europe plus Brazil and Chile) dominated by the German Reichsbank and bilateral trade agreements (German exports not devalued, imports became cheaper, dependency of “partners” on Germany increased – in Germany also public works program which gradually merges with rearmament (prohibited under treaty of Versailles) “gold block” led by France until 1936 – conventional politics until GS was abandoned US isolated itself and developed a recovery policy under president Roosevelt: The New Deal (public works, industry coordination, social security, see below. The results differ from country to country (see p. 21 on employment and production), but in general leaving the Gold Standard made an escape from debt deflation and more scope for domestic fiscal and monetary policy possible The end of the Gold Standard Because of the industrial, employment and banking crisis the convertibility of the British Pound into Gold was called into question in September 1931, when Britain experienced massive losses of gold as capital leaves the country and the balance of payments is in deficit. The Bank of England finally suspended the convertibility instead of inducing another round of deflationary monetary policy. How could that happen? side-effect of banking crises on the European continent (in 1931, Creditanstalt crisis, German banking crisis, etc.) little trust in the capacity of the Bank of England and the government to impose again severe deflationary politics to keep and regain gold, confronting the threat of a general strike, etc. On the free market, the Pound lost 30% of its value until December 1931 (i.e., devaluation instead of deflation in the UK). US followed in 1933, France in 1935. Germany since 1931: state administration of foreign exchange: the convertibility of Marks into gold and the free exchange of currency is suspended. Whoever needed foreign exchange, had to ask for a permit at the central bank. That is, gold standard in name only. From 1933, this policy became much more restrictive. 22 Gold standard ‘membership’, 1870-1940 Source: Obstfeld and Taylor (2004), p. 26. Consequences: Listen to John Maynard Keynes on Britain leaving the Gold Standard, 1 October 1931; “Professor Keynes is optimistic”. https://www.youtube.com/watch?v=0PYSFqCSsGU. Transcript: “there really seems to be some Providence which watches over this country. Two months ago we were in an impossible position, the years passed our industry had been strangled by the exchange value of our money being too high, with the inevitable result that the cost of our goods was also too high for foreign markets but how on earth were we to get loose in an honorable way, for our bankers who had accepted foreign money that high exchange value felt that it would be wrong for us to change the value of our money voluntarily. As events have turned out the change has been forced on us under circumstances extraordinarily fortunate and favorable, we have nothing to fear, honestly nothing. So often in the past ten years I have had to prophesy evil but now a great weight is lifted from us, a great tension relieved. There's no danger of the exchange falling too far; there's no danger of a serious rise in the cost of living – the worst I should expect will be returned to the prices of some two years ago but meanwhile British trade would have received an enormous stimulus, much more than most of us have yet realized. It is a wonderful thing for our businessmen and our manufacturers and our unemployed to taste hope again, that they must not allow anyone to put them back in the gold cage where they have been pining their hearts out all these years,“ Prices indeed stopped falling, without major inflation. Production recovered. Unemployment receded. (Britain, however, accompanied this with a mild increase in trade protection and especially a shift toward trading with its Empire, and gold standard countries like France used trade protection against Britain to offset the increased competitiveness of Britain Keynes talks about. So, Britain’s solution was good for Britain and eventually followed by others, but it would have been better it had been done in international coordination.) 23 Different experiences, 1929-31: Gold standard, unemployment and discontent in Germany and the UK Source: Persson and Sharp (2015), p. 217. Germany did temper with the Gold standard from 1931 but still followed its logic. The crisis in 1931 also was much deeper and the reaction of the German government much stricter than in Britain. All this austerity and balancing of government budgets for the sake of the confidence of international creditors had severe economic, social and polítical costs, as it eroded the basis for democracy in the Weimar Republic and helped the rise of Hitler’s party, who apart from extreme antisemitism and authoritarianism also attacked the government for the effect of austerity on agriculture and unemployment (Galofré-Vilà et al 2021). There is a lot of discussion in historiography about how much the German government could do given the treaties related to the Dawes and Young Plan that bound it to the gold standard. Also, the legacy of the hyperinflation potentially made the German government more inflation averse (similarly, in Austria, economic recovery after the 1931 crisis was very weak). But of course, this does not imply that German voters had to vote for the Nazi party! Also, de Bromhead, Eichengreen and O’Rourke (2013) demonstrate that such reaction generalizes (with different consequences) for extremist party votes in other countries. 24 8. Summary: Causes of the Great Depression Deflationary pressures from the Gold Standard and more restrictive central bank regulations instead of helping the banks to survive with “cheap money” (low interest rates, helping national credit supply), many central banks did the contrary: They raised interest rates to save their gold reserves and exchange rate [or they recapitalized the banks, but did not help the rest of the economy] To make this possible they also cut government budgets to meet falling tax revenues instead of “expansive fiscal policy” (credit-financed government investments in infrastructure, etc.) This is the contrary of what is taught and practiced today in monetary, fiscal policy and macroeconomics classes Fluctuations in prices and inventories of raw materials: During WWI demand exceeded supply, and prices rose, especially for war-oriented raw materials including food. Cultivated areas and industrial capacities increased. Once European agriculture recovers excess demand becomes excess supply. Heavy industry experienced similar ups and downs (partly, but only partly mitigated by the rise of the automobile industry, which was much weaker in Europe than in the US) International markets did not work either due to protectionist policies which were deepened with the Great Depression (i.e., trade was impeded from ‘balancing’) 25 8. Bibliography Findlay, R., O’Rourke, K.H. (2007). Power and Plenty Trade, War, and the World Economy in the Second Millennium. Princeton University Press, chapter 9. Eichengreen, B. (1995, 2008), Globalizing Capital: A History of the International Monetary System, Princeton University Press, chs. 1 and 2. Kindleberger, C.P. (1973/1986/2013). The World in Depression, 1929-1939, University of California Press. Graphs and Tables Reinhart, C.M., Rogoff, K.S. (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton University Press. Obstfeld, M., Taylor, AM. (2004). Global Capital Markets: Integration, Crisis, and Growth, Cambridge University Press. Lampe, M., Sharp, P. (2013). Tariffs and income: a time series analysis for 24 countries. Cliometrica 7(3), 207-235. Broadberry, S., Harrison, M., eds. (2005). The Economics of World War I. Cambridge University Press, chapter 1. Barro, RJ, Ursúa, JF, Weng, J (2020). The Coronavirus and the Great Influenza Pandemic: Lessons from the “Spanish Flu” for the Coronavirus’s Potential Effects on Mortality and Economic Activity. NBER Working Papr 26866, https://www.nber.org/papers/w26866 Aassve, A., Alfani, G., Gandolfi, F., Le Moglie, M. (2020). Epidemics and Trust: The Case of the Spanish Flu. IGIER (Universit’a Bocconi) Working Paper 661, http://www.igier.unibocconi.it/files/661.pdf Spoerer, M. (2015/2017). Öffentliche Finanzen. In: Thomas Rahlf (Ed.), Deutschland in Daten. Zeitreihen zur Historischen Statistik, Bonn: Bundeszentrale für politische Bildung 2015, pp. 102-113. / English translation: Mark Spoerer, Public Finances, in: www.deutschland-in-daten.de, 16.01.2017, http://www.deutschland-in-daten.de/en/public-finances. Jobst, C., Kernbauer, H. (2016). The quest for stable money. Central banking in Austria, 1816-2016. Frankfurt: Campus. Ritschl,A. (2012). Reparations, deficits, and debt default: the Great Depression in Germany. LSE Economic History Working Papers 44335, http://eprints.lse.ac.uk/44335/. White, E.N. (1990). When the ticker ran late: The stock market boom and crash of 1929. In: E.N. White (ed.): Crashes and panics: the lessons from history. Homewood, IL: Dow Jones-Irwin, chapter 5. Blattman, C., Hwang, J., Williamson, J.G. (2007). Winners and losers in the commodity lottery: The impact of terms of trade growth and volatility in the Periphery 1870–1939, Journal of Development Economics 82, 156-179, dataset here. Bernanke, B., James, H. (1991). The Gold Standard, deflation, and financial crises in the Great Depression: an international comparison. In: Robert G. Hubbard (ed.), Financial markets and financial crises, Chicago: Chicago University Press, pp. 33-68. 26 Eichengreen, B., Hatton, T.J. (1988). Interwar unemployment in international perspective: An overview. In: B. Eichengreen, T.J. Hatton (eds.). Interwar unemployment in international perspective, Dordrecht: Kluwer, pp. 1-59. Persson, Karl Gunnar, and Paul Sharp (2015), An Economic History of Europe, Cambridge University Press. de Bromhead, A., Eichengreen, B., O’Rourke, K.H. (2013). Political Extremism in the 1920s and 1930s: Do German Lessons Generalize? Journal of Economic History 73(2), 371-406. Galofré-Vilà, G., Meissner, C.M., McKee, M., Stuckler, D. (2021). Austerity and the Rise of the Nazi Party, Journal of Economic History 81(1), 81-113. 27