Lecture 7 - The spread of the Great Depression.pdf

Economic History The spread of the Great Depression Felix Ward Erasmus University Rotterdam 1/53 1 The Gold Standard literature 2 The Great Depression in Germany 3 Disintegration of the world economy 2/53 The Gold Standard literature1,2 The Great Depression was an international phenomen...

Economic History The spread of the Great Depression Felix Ward Erasmus University Rotterdam 1/53 1 The Gold Standard literature 2 The Great Depression in Germany 3 Disintegration of the world economy 2/53 The Gold Standard literature1,2 The Great Depression was an international phenomenon Similarly, tight monetary policy was an international phenomenon Why? ⇒ A consequence of the Gold Standard 1 Eichengreen, Barry. 1992. Golden fetters: the Gold Standard and the Great Depression, 1919-1939. Oxford University Press 2 Temin, Peter. 1989. Lessons from the Great Depression. Cambridge: MIT Press 3/53 How did the Gold Standard work? 1 Monetary authority fixed gold price of the local unit of account (e.g. 1 USD = 1.505 grams of fine gold) 2 Domestic money is freely convertible into gold at this price ⇒ Two countries on gold had a fixed exchange rate Example: 1 GBP = 7.32238 grams of fine gold ⇒ 1 GBP = 4.87 USD 4/53 Gold coverage 5/53 The gold coverage ratio Legal gold cover ratios λ typically were 25% to 40% e.g. Netherlands: λ = 40% Actual gold cover ratios λt fluctuated around legal ones: λt = P G · Gt Baset PG = officially fixed gold price (e.g. 0.6048 g per Gulden) Baset = Monetary base Gt = Quantity of monetary gold 6/53 The rules of the game Central banks targeted the cover ratio by setting interest rates it it = i + α(λt − λ), α<0 i: natural interest rate Cover ratio below target ⇒ raise interest rate: i ↑ 1 Gold inflows: Gt ↑ 2 Lower money demand: Baset ↓ ⇒ Cover ratio increases: λt = PG ·Gt Baset ↑ 7/53 The rules of the game Global gold supply is fixed ⇒ gold in- and outflows offset each other Rules of the game: keep money supply proportional to gold reserve 1 Gold inflow countries had to expand their money supply proportionally (no sterilization) 2 Gold outflow countries had to contract their money supply proportionally (accept deflation) ⇒ Global money supply stable; regional ups and downs 8/53 Hume’s price-specie flow model: an illustration1,2 U.S. trade deficit (NXUS < 0) U.K. trade surplus (NXUK > 0) Gold outflows = −NXUS Gold inflows = NXUK = −NXUS Money supply decreases Money supply increases Prices fall Prices rise Price competitiveness improves Price competitiveness deteriorates Net exports rise Net exports fall ⇒ Adherence to the rules of the game brings about region-specific monetary policies that facilitate external adjustment 1 Hume, David. 1752. Political discourses. A. Kincaid & A. Donaldson. Committee on Currency and Foreign Exchanges after the War. 1919. First Interim Report. Cd. 9182, London: HMSO. 2 9/53 Gold Standard in 1913 10/53 The interwar Gold-exchange Standard During WW1: Gold Standard was suspended Genoa conference 1922: resumption of gold convertibility, but central banks were encouraged to hold part of their reserves in the form of foreign exchange (USD and GBP notes) rather than gold λt = PG · Gt + FXt Rest ≡ Baset Baset FXt = foreign exchange reserves (in domestic units of account) Rest = Reserves Reasons for the change: 1 Avoid deflation (gold supply grew less than world economy) 2 Keep gold in the vaults (lower transaction costs) 11/53 The Gold Standard and the macroeconomic policy trilemma Stable exchange rate Trilemma: pick 2 out of 3 Gold Standard: 1 Capital mobility 2 Stable exchange rates 3 Independent monetary policy Capital mobility Independent monetary policy Reason: Capital mobility ⇒ i = i∗ · Et st+1 st (uncovered interest parity) Stable exchange rate ⇒ Et st+1 st = 1 ⇒ i = i∗ 12/53 The Gold Standard Literature: rules of the game violations Great Depression was initiated by two rules of the game violations 1 U.S.: raised rates in 1928 despite high gold cover ratio 2 France: sterilized massive gold inflows in late 1920s ⇒ Adds to 1929 capital flow reversals (e.g. Germany’s sudden stop) ⇒ Forces other central banks to raise rates to prevent gold outflows 13/53 6 4 2 Short term interest rates 8 Rule violation #1: U.S. rate hikes trigger global rate hikes 1927 1928 U.S. France 1929 U.K. Sweden 1930 Germany Netherlands Data source: Macrohistory Database, http://www.macrohistory.net/data/ 14/53 Global M1 growth slows down in late 1920s Eichengreen, Barry. 1992. Golden fetters: the Gold Standard and the Great Depression, 1919-1939. Oxford University Press 15/53 Rule violation #2: France becomes a global gold sink Resumption of gold convertibility is not coordinated internationally Some return to gold at pre-WW1 gold price: e.g. U.K. Others don’t reverse WW1 inflation: e.g. France Poincaré stabilization (1926) → undervaluation of the Franc Massive gold inflows into France Banque de France sterilizes gold inflows Irwin, Douglas A. 2010. Did France cause the Great Depression? NBER Working Paper No. 16350. 16/53 Figure 3: Cover R France accumulates disproportionate share of global gold 14,000 millions of dollars (1929 gold content) 10,000 Others 8,000 Germany United Kingdom 6,000 France United States 4,000 2,000 - !! ratio of central bank gold to domestic liabilities 0.90 12,000 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 1925 1926 1927 1928 1929 1930 1931 1932 Figure: Global gold reserves (million USD), 1925-1932 Source: Hardy (1936, 92). Note: Data are for Source: Calculate Irwin, Douglas A. 2010. Did France Cause the Great Depression? NBER Working Paper No. 16350 17/53 Figure 3: Cover Ratios of Major Central Banks, 1928-1932 France sterilizes gold inflows ratio of central bank gold to domestic liabilities 0.90 0.80 France 0.70 0.60 United States 0.50 0.40 0.30 0.20 United Kingdom 0.10 0.00 1928 1929 1930 1931 1932 ! Figure: Gold cover ratios, 1928-1932 Note: Data are for December of each year. Source: Calculated from the Board of Governors of the Federal Reserve System (1943). 18/53 The asymmetry problem1 Gold outflow countries Gold inflow countries Gold outflows: Goldout ↓ Gold inflows: Goldin ↑ Gold cover ratio falls: Resout ↓ Baseout < λ Gold cover ratio rises: Resin ↑ >λ Basein Monetary contraction to safeguard gold cover ratio: No urgent need for monetary expansion ⇒ sterilization: Resout ↓ Baseout ↓ Resin ↑ Basein Gold Standard literature: Rules of the game violations gave rise to global monetary contraction: Baseglobal ↓= Basein + Baseout ↓ 1 Simmons, Beth A. 1994. Who adjusts? Domestic sources of foreign economic policy during the Interwar years. Princeton University Press. 19/53 The Gold-exchange Standard reaches a breaking point in 1931 International investors begin to doubt stability of the Gold Standard ⇒ Currency crises begin: runs on central banks June 1931: Run on Mark Germany raises interest rate and implements capital controls, Exchange controls group follows: Austria, Hungary, Bulgaria,... September 1931: Run on Pound Sterling U.K. raises interest rate and leaves gold, Sterling bloc follows: India, Finland, Norway, Sweden, Portugal, Japan, Thailand,... October 1931: Run on Dollar U.S. raises interest rate 20/53 The 1931 currency crises add to the global monetary contraction The 1931 currency crises had two effects on central banks’ reserve management 1 Flight from FX reserves: central banks stop treating FX reserves as equivalent to gold reserves (Resglobal ↓= Goldglobal + FXglobal ) 2 Scramble for gold: central banks want to increase their gold cover ratios as insurance against similar runs in the future global Res Desire to increase Base global global but Res = Goldglobal is globally fixed global Resglobal ⇒ Base ↓ global can only be increased through Base ⇒ Currency crises and ensuing reserve management changes result in even more global monetary contraction 21/53 Flight from foreign-exchange at the Bank of France Accominotti, Olivier. 2009. The sterling trap: foreign reserves management at the Bank of France, 1928–1936. European Review of Economic History, 13. 22/53 The Gold Standard continues to fully disintegrate after 1931 1933: U.S. leaves gold 1936: Gold bloc collapse (France, Belgium, Netherlands, Switzerland) Why? After the Sterling bloc had devalued it received gold inflows No further devaluations expected ⇒ Sterling bloc is safe haven Increased price competitiveness ⇒ net exports increase (beggar-thy-neighbor effect) New rules of the game violation: Sterling bloc sterilizes inflows ⇒ Asymmetry problem gets passed on ⇒ Countries staying on gold increasingly end up on the contractionary side of the asymmetry problem 23/53 Passing on the asymmetry problem Almunia, Miguel, Augustín Bénétrix, Barry Eichengreen, Kevin H. O’Rourke and Gisela Rua. 2010. Lessons from the Great Depression. Economic Policy, pp. 219–265. 24/53 The Great Depression spreads to the gold bloc after 1931 Romer, Christina. 1993. The nation in depression. Journal of Economic Perspectives, 7(2). 25/53 The global monetary contraction in one equation Global M1 can be decomposed into the following terms: M1 = (M1/Base) x (Base/Res) x (Res/Gold) xGold | {z } | {z } | {z } Money multiplier Cover ratio FX ratio M1/Base ↓ bank failures, credit crunches ← banking crises Base/Res ↓ asymmetry problem, scramble for gold ← currency crises Res/Gold ↓ flight from FX reserves ← currency crises Gold Standard literature: this causes the global Great Depression Bernanke, Ben S. 1995. The macroeconomics of the Great Depression: a comparative approach. The Journal of Money, Credit and Banking, 27(1). 26/53 Problem with the global monetary thesis: risk-free rates fall... 6 Percent 5 4 3 1929 1931 Global risk-free rate 1933 1935 Figure: Risk-free rate, global GDP-weighted average across 17 non-U.S. countries ⇒ Difficult to reconcile with monetary contraction as the main driver of the Great Depression Data from: Macrohistory Database, http://www.macrohistory.net/data/ 27/53 ...but corporate bond yields rise Global corporate bond yield Global credit 10 100 Index, 1929=100 Percent 9 8 7 6 1929 1931 1933 1935 95 90 85 1929 1931 1933 1935 Figure: GDP-weighted averages across 17 non-U.S. countries ⇒ Global credit crunch Data from: Macrohistory Database http://www.macrohistory.net/data/; credit spread – Kuvshinov, Dmitry. 2021. The Co-Movement Puzzle. Working Paper. 28/53 In 1931 banking crises erupt all around the world Taylor, Alan M. The Great Leveraging. In: The Social Value of the Financial Sector: Too Big to Fail or Just Too Big?. Eds.: V. V. Acharya, T. Beck, D. D. Evanoff, G. G. Kaufman, and R. Portes, Vol. 29. World Scientific Studies in International Economics, 33–66. Hackensack, NJ: World Scientific Publishing, 2012. 29/53 Causes of the global banking crisis in 1931 Financial fragility: high debt levels WW1 overextension of farms (esp. U.S. and primary producers) Rising debt levels during roaring 1920s Second year of the recession Incomes had fallen ⇒ harder to service debt Asset prices had fallen ⇒ weaker balance sheets Contagion Worsening of expectations (e.g. Austria → Germany?) Cross-border financial exposure (e.g. Germany → U.K., U.S.) 30/53 Did the Gold Standard cause the 1931 global banking crisis? Trilemma: exchange rate stabilization conflicts with central bank’s lender of last resort function 1 Save banks by providing liquidity to banks ⇒ increases pressure on exchange rate: currency crisis 2 Defend the fixed exchange rate by increasing the interest rate ⇒ aggravates banks’ liquidity problems: banking crisis Twin crises (banking and currency) were common in 1931 (e.g. Germany, U.S.) Grossman (1994): Best predictor whether a country had a banking crisis in 1931 is whether it was on the Gold Standard Grossman, Richard. 1994. The shoe that didn’t drop: explaining banking stability during the great depression. Journal of Economic History, 54. 31/53 1 The Gold Standard literature 2 The Great Depression in Germany 3 Disintegration of the world economy 32/53 Payback time Since 1924: Germany had payed reparations with borrowed USD Since 1929: Germany can’t borrow (Young Plan & sudden stop) Needs current account surpluses to earn foreign exchange with which to pay off and service foreign debt and reparations A country’s budget constraint (2 periods): Dt ≤ PCAt + Et PCAt+1 , and ∆Dt = −PCAt + rDt (1 + rt ) D: net external debt E: expectations operator PCA: primary current account surplus rD: net debt servicing cost t+1 Since 1924: −PCAt + rDt > 0, ∆Dt > 0 and Et PCA (1+rt ) >> 0 Since 1929: 2nd period had arrived suddenly ⇒ PCA ↑ or default 33/53 How to pay reparations once U.S. capital inflows had stopped? German chancellor Brüning’s answer: Austerity Conflicting interpretations: 1 Revisionist: exacerbate recession to attain reparation relief 2 Best possible economic policy given severe political constraints Boost net exports by improving Germany’s price competitiveness through an internal devaluation Brüning’s strategy was supported by economists e.g. Joseph Schumpeter: deflate further and then radically change course later on 34/53 External adjustment with austerity under fixed exchange rates i Austerity: G ↓ 7∗ ∆"# 1 AD0 → AD1 2 Increasing price competitiveness crowds in net exports: IS0.1 → IS1 $'( ∆. $%& $%&.) $%) Y * +%& Severity or recession depends on 1 Slope of AS 2 Speed of AS adjustment: expectations and nominal rigidities *∗ +,& (./0 , "#23 ) +,) (.23 , "#/0 ) Y e.g. Burda, Michael and Charles Wyplosz. 2017 [7th edition]. Macroeconomics. Ch. 14. 35/53 Economic policy options were limited Germany already on brink of sovereign default in 1929 No access to private capital market International stabilization loans came with strings attached: budget and wage cuts, reduction in administered prices,... 1 This conditionality explains part of Brüning’s austerity policy Unilateral default? Risked renewed sanctions; Rhineland occupation had only ended in 1930 Devaluation to boost exports? Fear that devaluation would trigger inflation was widespread2 Adjusting Reichsbank gold policy required international consent 1 Ritschl, Albrecht. 2013. Reparations, deficits, and debt default: the Great Depression in Germany. In: The Great Depression of the 1930s: lessons for today. 2 Straumann, Tobias. 2009. Rule rather than exception: Brüning’s fear of devaluation in comparative perspective. Journal of Contemporary History, 44(4). 36/53 Germany’s fiscal contraction and its effect on the trade balance Size of the fiscal contraction: In 1928/29: public expenditures/GDP = 30% Between 1930 and 1932: nominal expenditures were cut by 30% (14% in real terms due to deflation) ⇒ Large negative demand shock Austerity policies achieve export surpluses, but only through a fall in imports, whereas exports didn’t rise, partly due to bad timing Export opportunities vanish due to global trade war Gold exits hurts Germany’s competitiveness ⇒ Fiscal contraction (G ↓) not offset by rising exports (X ↑); depression exacerbated 37/53 The Hunger chancellor: Germany’s fiscal contraction Galofré-Vilà, Gregori, Christopher M. Meissner, Martin McKee, and David Stuckler. 2021. Austerity and the rise of the Nazi party? The Journal of Economic History, 81(1). 38/53 No exports to dampen the fiscal contraction are forthcoming 20 Percent 15 10 5 0 -5 1924 1926 Net exports-to-GDP 1928 1930 Exports-to-GDP 1932 Imports-to-GDP External adjustment through expenditure reduction (IM ↓) rather than expenditure switching (X ↑) Data from: NBER Macrohistory Database 39/53 Industrial production (June 1929=100) 50 60 70 80 90 100 Severe output contraction 1928m1 1930m1 1932m1 1934m1 Data from: Albers, Thilo. 2018. The Prelude and Global Impact of the Great Depression Evidence from a New Macroeconomic Dataset. Explorations in Economic History, 70. 40/53 Political ramifications: Germany becomes ungovernable Nondemocratic parties begin to dominate Germany’s parliament First electoral success of Nazi party in September 1930 (18%) Government becomes minority coalition in German parliament Since September 1930 chancellor Brüning can only enact austerity policies via emergency decrees ⇒ Further undermines political support for Weimar Republic 41/53 The crisis of 1931 in Germany Sequence of political and financial news initiate the 1931 crisis: Banking problems: after Austrian Creditanstalt crisis in May 1931 foreign depositors begin to withdraw money from Berlin banks Fiscal problems: Brüning government’s “limits of privations” statement raises questions about Germany’s willingness to pay ⇒ Investors want to get their money out, Reichsbank reserves decline, currency crisis begins As in July 1931, large German banks have payment difficulties the Trilemma bites once again: 1 Initially Reichsbank acts as lender of last resort and keeps banking system liquid ⇒ gold cover ratio plummets 2 Reichsbank reverses course and tries to defend gold through interest rate hikes ⇒ failure; banking crisis erupts 3 In August 1931 Reichsbank implements capital controls 42/53 Defense of the Gold Standard leads to monetary contraction 6.5 10 6 8 5.5 6 4 1928m1 Monetary base (billion RM) Reichsbank discount rate 12 5 1930m1 date Reichsbank discount rate 1932m1 1934m1 Monetary base Data from: NBER Macrohistory Database and Ritschl, Albrecht. 2002. The German business cycle, 1924-1934: domestic activity, foreign debt, and reparations from the Dawes Plan to the Debt Default. Berlin: Akademie-Verlag. 43/53 Like others, Germany also experiences a credit crunch M1 money multiplier Credit spread 3.8 9 Percent 3.6 3.4 5 3.2 3 1928 7 1930 1932 3 1928 Policy rate Corporate bond yield 1930 1932 Data from: Ritschl, Albrecht. 2002. The German business cycle, 1924-1934: domestic activity, foreign debt, and reparations from the Dawes Plan to the Debt Default. Berlin: Akademie-Verlag; Kuvshinov, Dmitry. 2021. The Co-Movement Puzzle. Working Paper 44/53 100 meters before the finish line International banking crisis leads to the Hoover Moratorium in Summer 1931: reparation payments suspended for one year In summer 1932 Lausanne Conference effectively ends reparation payments Brüning fails 100 meters before the finish line Released as chancellor in May 1932 Immediate successors (von Papen and von Schleicher) begin to implement expansionary policies ⇒ Recovery from the Great Depression begins in Germany January 1933 Hitler becomes German chancellor 45/53 Brüning’s economic policy underestimated the political risks McKee et al (2021): 1% real expenditure reduction ⇒ 0.683-0.896 ppt increase in NSDAP vote share Source: Stögbauer, Christian. 2001. The radicalisation of the German electorate: swinging to the Right and the Left in the twilight of the Weimar Republic. European Review of Economic History, 5. Galofré-Vilà, Gregori, Christopher M. Meissner, Martin McKee, and David Stuckler. 2021. Austerity and the rise of the Nazi party? The Journal of Economic History, 81(1). 46/53 1 The Gold Standard literature 2 The Great Depression in Germany 3 Disintegration of the world economy 47/53 Disintegration of the world economy The capital controls that were introduced in the wake of the 1931 global financial crisis led to a lasting financial market disintegration In addition, the Great Depression was accompanied by a global trade war which led to goods market disintegration The trade war started with the U.S. Smoot-Hawley tariff in June 1930 Goal: support domestic farmers (post-WW1 overcapacity) ⇒ Generated retaliatory response from U.S. trading partners The trade war intensified after 1931: gold remainers try to offset their competitiveness loss vis-à-vis gold leavers through tariffs 48/53 The Depression spreads: tariff increases and trade collapse Throughout the Great Depression tariffs increase This was supplemented by import quotas Gold bloc countries increased tariffs more than others Trade collapse carries the Depression to small open economies e.g. Perri and Quadrini (2002): 50% of Great Depression in Italy due to trade collapse brought about by trade war Perri, Fabrizio and Vincenzo Quadrini. 2002. The Great Depression in Italy: Trade restrictions and real wage rigidities. Review of Economic Dynamics, 5. 49/53 Global goods markets disintegrate Figure: Average protection rates, 30 countries, 1926–1938 Data source: Mitchell, Brian R. 2007. International Historical Statistics. Palgrave Macmillan. 50/53 Devaluations fuel the trade war Figure: Exchange rate and change in import tariffs, 1929–1935 ⇒ Gold bloc countries increased tariffs most Eichengreen, Barry and Douglas A. Irwin. 2010. The slide to protectionism in the Great Depression: who succumbed and why?. The Journal of Economic History, 70(4). 51/53 International trade falls even faster than output Kindleberger, Charles P. 1986. The world in depression, 1929-1939. Vol. 4. University of California Press. 52/53 Summary Dysfunctional Gold-exchange Standard leads to global monetary contraction 1931 global financial crisis gives rise to global credit crunch The German Great Depression has a special fiscal component Foreign debt problem necessitates large fiscal contraction ⇒ Severe depression Capital controls and the trade war lead to a lasting disintegration of the world economy 53/53