Lecture 5 - The 1920s.pdf

Economic History The 1920s: Prelude to the Great Depression Felix Ward Erasmus University Rotterdam 1/45 Overview of the Great Depression 1929–1932: 36% drop in global industrial production1 Decline most severe in the U.S. (-46%) and Germany (-47%) Decline milder in Japan (-2%), Sweden (-4%), No...

Economic History The 1920s: Prelude to the Great Depression Felix Ward Erasmus University Rotterdam 1/45 Overview of the Great Depression 1929–1932: 36% drop in global industrial production1 Decline most severe in the U.S. (-46%) and Germany (-47%) Decline milder in Japan (-2%), Sweden (-4%), Norway (-7%), Denmark (-9%), Netherlands (-16%), and the U.K. (-17%) Unemployment reached unprecedented levels Industrial unemployment rate peaks highest in the U.S. (38%) and Germany (44%) The Great Depression’s epicenters lay in the U.S. and Germany 1 Data source: League of Nations, Statistical Year-Books. 2/45 Industrial production Eichengreen, Barry. 1992. The origins and nature of the Great Slump revisited. Economic History Review, XLV(2). 3/45 Unemployment rates Eichengreen, Barry and Timothy J. Hatton. 1988. Interwar unemployment in international perspective: an overview. in: Interwar Unemployment in International Perspective. Eds.: Eichengreen, Barry and Timothy J. Hatton. 4/45 1 Overview of the Great Depression 2 The Roaring Twenties 3 War debts, reparations, and hyperinflation 4 Balance of payment problems 5/45 The Roaring 1920s in the U.S. Consumption boom: 1920: 8 million cars, 1 per 4 households 1929: 23 million cars, 1 per 1.5 households In 1929 alone, more than 4.5 million cars were sold (>50% on credit) Building boom: In 1920: 247.000 new houses were built At the housing boom’s peak in the mid 1920s it was 937.000 new units 6/45 The New Economy of the Roaring Twenties Lebergott, Stanley. 1962. The American Economy: Income, Wealth and Want. Princeton University Press. 7/45 120 110 100 Real GDP p.c. (index, 1913=100) 130 U.S. real output per capita in the 1920s 1920 1922 1924 1926 1928 1930 Data source: Macrohistory Database, http://www.macrohistory.net/data/ 8/45 Herbert Hoover: final triumph We in America today are nearer to the final triumph over poverty than ever before in the history of any land. We have not yet reached the goal, but, given the chance to go forward with the policies of the last eight years, we shall soon, with the help of God, be in sight of the day when poverty will be banished from this nation. U.S. President Herbert Hoover, 1928 9/45 Financial booms Mortgage lending boom e.g. Florida’s development as holiday and retiree destination Equity market boom Superstar bankers Credit-financed equity purchases Strong credit growth among households Driven by financial innovations such as installment loans for car purchases Optimism about the prospects of the New Economy underpin a financial euphoria 10/45 Real estate boom Unusually high post-WW1 family formation rate in 1920s Share of mortgage credit funding increases: less than 45% before WW1; nearly 60% in 1920s Figure: Net real construction expenditures, 1889–1939 White, Eugene N. 2014. Lessons from the Great American real estate boom and bust of the 1920s. in: Housing and Mortgage Markets in Historical Perspective. Eds.: White, Eugene N., Kenneth Snowden and Price V. Fishback. 11/45 .18 .16 .14 .12 .1 Mortgage credit-to-GDP ratio .2 U.S. mortgage debt-to-GDP ratio doubles 1921 1923 1925 1927 1929 Data source: Macrohistory Database, http://www.macrohistory.net/data/ 12/45 Household indebtedness Financial obligations of households double between 1919 and 1929 Especially installment debt increases (> 250%) Olney, Martha L. 1999. Avoiding default: the role of credit in the consumption collapse of 1930. The Quarterly Journal of Economics, 114(1). 13/45 Equity prices and dividends Until late 1926, equity prices follow dividends After 1926 a decoupling can be observed Credit-financed stock purchases (Brokers’ Loans) Rappoport, Peter and Eugene White. 1993. Was there a bubble in the 1929 stock market? The Journal of Economic History, 53(3). 14/45 Brokers’ loans Kindleberger1 : positive feedback loop between credit and stock prices Speculation effect: credit ↑ ⇒ stock prices ↑ Balance sheet effect: stock prices ↑ ⇒ wealth ↑ ⇒ credit ↑ Eugene White. 1990. Stock market boom and crash of 1929 revisited. Journal of Economic Perspectives, 4(2). 1 Kindleberger, Charles P. 1973. The world in depression, 1929-1939. Allen Lane the Penguin Press. 15/45 Financial instability hypothesis Minsky/Kindleberger: Alternation of financial euphoria and depression lead to large aggregate demand fluctuations Euphoria phase Initial shock gets investors excited: new technology (e.g. cars) Credit boom; often also financial innovation (e.g. brokers’ loans) Positive feedback loop: credit expansion ⇔ rising asset prices ⇒ Aggregate demand rises (wealth effect & Tobin’s Q) Kindleberger, Charles P. 1978 [2005]. Manias, Panics, and Crashes. Wiley. Minsky, Hyman, P. 1986 [2008]. Stabilizing an Unstable Economy. McGraw Hill. Harrison, Sharon G. and Mark Weder. 2006. Did sunspot forces cause the Great Depression? Journal of Monetary Economics, 53. 16/45 Financial instability hypothesis As debt-to-income ratio rises, economy grows increasingly fragile 1 Hedge finance: Income ≥ debt service and repayment 2 Speculative finance: Income = debt service 3 Ponzi finance: Income < debt service Minsky moment: Once the economy is highly indebted, minor bad news can trigger a financial crisis (e.g. interest rate increase) Depression phase: Feedback loop reverses: credit contraction ⇔ falling asset prices ⇒ Aggregate demand falls (wealth effect & Tobin’s Q) 17/45 Pro-cyclical credit supply Exciting new technology Wealth effect Balance sheet effect Credit ↑ Asset prices ↑ Op tim ism ab ou tn ew Tobin’s Q tec h no lo gy Investment demand ↑ Higher profits Consumption demand ↑ a th Speculation ism tim Op c in ut bo e om ow gr Aggregate demand ↑ Minsky moment: Positive feedback loop goes into reverse 18/45 The Fed’s contractionary turn in 1928/1929 Increasing concern about stock price bubble and boom in brokers loans leads to debate about the right measure to curtail speculation Direct pressure (Fed Board) vs. interest rate increase (NY Fed) In the late 1920s the Fed increased interest rate from 3.5% to 6% Economy slows: industrial production peaks in August 1929 Stock market crash begins in October 1929 The U.S. Great Depression begins 19/45 1 Overview of the Great Depression 2 The Roaring Twenties 3 War debts, reparations, and hyperinflation 4 Balance of payment problems 20/45 Germany’s path into the Great Depression 1918: Foundation of German Republic (Weimar Republic) Challenges: 1 Social demands and transition to welfare state 2 War costs and reparations 3 Strong opposition to democracy in politics and business Political problem: Finance welfare state and pay reparations, without threatening economic growth which would strengthen the opponents of the Weimar Republic 21/45 Social demands and transition to welfare state Threefold increase in social expenditures 1 Social care (esp. war veterans, widows, and orphans) 2 Housing construction 3 Unemployment insurance Introduction of new income tax raises revenues Erzberger’s tax reform 1919/1920 Increase in top tax rate from 10% to 60% Large deficits: Between 1913 and 1925, an increase in tax revenues from 8% to 16% of GDP was outpaced by an increase in public expenditures from 15% to 30% of GDP 22/45 War costs Costs for 800.000 veterans, 500.000 widows and 1 million orphans Employment at the national railway and postal service is extended Pre-WW1: national railway employed 750.000; post-WW1: 1 mio One quarter of government’s deficit due to national railway These so-called domestic reparations would have led to substantial increase in government expenditures even without external reparation payments 23/45 Reparations and war debts Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the Great Depression 1919–1939. Oxford University Press. 24/45 German reparations, the deficit, and rising inflation 1921–1922: reparations accounted for the bulk of the public deficit Raising new taxes to pay for reparations is a political non-starter Government needs to issue lots of debt ⇒ Reichsbank monetizes substantial part of it Inflation was the only tax that was politically acceptable Hugo Stinnes: “The choice is between inflation and revolution. I choose inflation.” Eichengreen (1992): reparations responsible for the inflation Feldman (1997): The unavoidable inflation? 1 Eichengreen, Barry. 1992. Golden Fetters: The Gold Standard and the Great Depression 1919–1939. Oxford University Press. 2 Feldman, Gerald D. 1997. The Great Disorder: Politics, Economics, and Society in the German Inflation, 1914–1924. Oxford University Press. 25/45 Large deficits in the immediate postwar years Ferguson, Niall. 1996. Constraints and room for manoeuvre in the German inflation of the early 1920s. Economic History Review, XLIX(4). 26/45 The way into the hyperinflation of 1923 At the end of 1922 the conflict about reparation payments escalates, in response to which French troops occupy the Rhineland Ruhr campaign: German government calls for a general strike and passive resistance in the occupied territories Wages of around two million workers were payed by the government Mostly debt financed and monetized by the Reichsbank German hyperinflation begins 27/45 Ruhr campaign leads to monetization of ever larger deficits German prices increase rapidly German currency depreciates rapidly 8000 RM/USD in December 1922 20,000 RM in April 100,000 RM in September 4,200,000,000,000 RM/USD in November 1923 Sargent, Thomas J. 1982. The ends of four big inflations. in: Inflation: Causes and Effects. Ed.: Robert E. Hall. University of Chicago Press. 28/45 Monetary theory versus fiscal theory of the price level Monetary theory: Mt Vt = Pt Yt Fiscal theory (2 periods): Bt /Pt ≤ st + Et st+1 (1 + rt ) P: price level B: nominal public debt M: money stock E: expectations operator V: money velocity s: real government surplus Y: real output r: real discount rate ⇒ For given V and Y: by setting M, the monetary authority determines P ⇒ For given B and r: by chosing st and st+1 , the fiscal authority determines P ⇒ Shortfall in (expected) surpluses implies inflation or default 29/45 Why was default not an option? External default: would destroy post-WW1 settlement and risk occupation / resumption of hostilities Internal default: political suicide for government Does fiscal or monetary policy determine the price level? Depends on intra-governmental power relations1 Monetary dominance: monetary authority sets rt , Mt ⇒ fiscal authority plans its budget accordingly Fiscal dominance: fiscal authority sets path for st ⇒ monetary authority has to monetize any shortfall to avoid default 1 Sargent, Thomas J., Wallace, N., 1981. Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review, pp. 1–17. 30/45 Was fiscal or monetary policy dominant in hyperinflation Germany? Reichsbank gave fiscal authorities confidential advice which blamed inflation on the government’s debt But fiscal policy was under no obligation to heed the Reichsbank’s advice ⇒ Fiscal policy dominates, but is unable to achieve surpluses consistent with price stability owing to political gridlock (tax hikes, expenditure cuts) ⇒ Inflation becomes only politically feasible tax 31/45 Factors contributing to Germany’s hyperinflation 1 Conflictual relations1 : Workers vs. capitalists: collective bargaining and strikes, revolutionary threat, wage indexation (wage-price spiral) Revisionist policies: assumes strong public finances are bad for future reparation negotiations Radicalization: assassinations of finance minister (1921) and foreign minister (1922), paramilitary Putsch attempts ⇒ Budget deficits (Et st+1 ↓) 2 Monetary confusion2 : Officially, Reichsbank blames inflation on reparations: ⇒ NER ↓ ⇒ PImports ↑ ⇒ P ↑ Reichsbank fears liquidity shortage: P ↑ ⇒ MD ↑ ⇒ i ↑ ⇒ MS ↑ Misguided focus on stabilizing i leads to Taylor principle violation (e.g. discount rate fixed at 8% while inflation already >20%) ⇒ Monetary policy accommodative NER: exchange rate, P: price level, MD : money demand, MS : money supply, i: nominal interest rate 1 Feldman, Gerald D. 1997. The Great Disorder: Politics, Economics, and Society in the German Inflation, 1914–1924. Oxford University Press. 2 Humphrey, Thomas M. 1980. Eliminating runaway inflation: lessons from the German hyperinflation. Federal Reserve Bank of Richmond Economic Review, (July/August): 3–7. 32/45 10#$ 10## 10#% 10& 10' 10( 10) 10* 10+ 10, 10$ 10 1.00 1 .75 1920 .50 .25 .00 1920 1921 1922 1923 33/45 Figure: Indices, 1913=1 1921 1922 1923 Humphrey, Thomas M. 1980. Eliminating runaway inflation: lessons from the German hyperinflation. Federal Reserve Bank of Richmond Economic Review, (July/August): 3–7. Prices outpace money: real money falls The miracle of the Rentenmark 34/45 Monetary and fiscal reform Monetary reform: new currency and end of debt monetization Introduction of the Rentenmark (Nov 15th, 1923): Rentenbank which takes over central functions of the Reichsbank Maximum of 3.2 billion Rentenmark could be issued; of which no more than 1.2 billion to the government Reichsbank ordered to stop discounting treasury bills Fiscal reform: drastic government expenditure reduction 25% of all public employees were laid off 120,000 of which were employees of the national railway Government budget balanced, reparations rescheduled 35/45 Stabilization Rentenbank refuses new loans to government Dawes Plan, 1924: reparations rescheduled Primary budget turns positive ⇒ Sargent1 : credible regime change 1 Sargent, Thomas J. 1982. The ends of four big inflations. in: Inflation: Causes and Effects. Ed.: Robert E. Hall. University of Chicago Press. 36/45 Dawes Plan (1924) Rescheduling: Reduction of reparation payments to 1 billion Marks/year until 1928; from 1928 onwards: 2.5 billion International oversight Reichsbank and national railway put under international control Reparation agent in Berlin supervises financial situation Transfer protection: reparation payments become junior debt vis-à-vis private capital incomes Attracts private capital inflows Germany begins to recycle USD inflows for reparations 37/45 Germany begins to recycle U.S. capital inflows Capital incomes (senior) Investment projects (e.g. swimming pools) (RM) U.S. War debts (USD or gold) Loans (USD → RM) Germany France/U.K. Reparations (USD or gold) Germany receives enough foreign exchange to pay its reparations 38/45 120 100 80 60 Real GDP p.c. (index, 1913=100) 140 Short recovery in the Roaring Twenties 1920 1925 1930 Germany 1935 U.S. Data source: Macrohistory Database, http://www.macrohistory.net/data/ 39/45 Effects of the hyperinflation Distributional effects: Winners: debtors Neutral: owners of real assets, workers Losers: owners of nominally fixed assets (e.g. money holders, creditors), and recipients of nominally fixed incomes (pensioners, civil servants) ⇒ Erosion of political support for Weimar Republic Limited economic policy space in the subsequent Depression Expansionary economic policies became political no-go 40/45 1 Overview of the Great Depression 2 The Roaring Twenties 3 War debts, reparations, and hyperinflation 4 Balance of payment problems 41/45 Capital inflows slow down in 1927 Reichsbank intervention (1927) reins in stock prices1 Berlin stock exchange begins to fall in May 1927 Capital inflows from the U.S. begin to fall ⇒ Balance of payment problem: How to get USD to pay for reparations? 1 Voth, Hans-Joachim. 2003. With a bang, not a whimper: Pricking Germany’s “stock market bubble” in 1927 and the slide into depression. Journal of Economic Perspectives, 63(1). Eugene White. 1990. Stock market boom and crash of 1929 revisited. Journal of Economic Perspectives, 4(2). 42/45 Turnaround in Germany’s balance of payments Table: German balance of payments (million Reichsmark) Ritschl, Albrecht. 2012. Reparations, deficits, and debt default: The Great Depression in Germany. Working Paper No. 163/12 43/45 Young Plan (1929) intensifies the balance of payment problem In 1929 the Young Plan replaces the Dawes Plan: Abolition of transfer protection ⇒ Sudden stop1 of capital inflows Consequences: End of credit-financed reparation payments ⇒ Germany needs trade surplus to obtain USD to pay back debt German investment falls (swimming pools) The German Great Depression begins 1 Calvo, Guillermo A. 1998. Capital flows and capital-market crises: the simple economics of sudden stops. Journal of Applied Economics, 1(1). 44/45 Summary The U.S.’s path into the Great Depression U.S. Great Depression is preceded by large financial booms in the Roaring Twenties The U.S. Great Depression begins with contractionary monetary policy and a stock market crash Germany’s path into the Great Depression WW1 results in a fiscal crisis and a balance of payment problem The Dawes Plan temporarily suspends these problems and allows Germany to join the Roaring Twenties The German Great Depression begins as the old problems resurface with the Young Plan (1929) ⇒ sudden stop 45/45