A Note on the Economic Recovery in the 1930s. 1

Transcription

1 K.G. Persson: A Note on the Economic Recovery in the 1930s. 1 Europe The Great Depression was not only an unprecedented economic shock to output, employment and prices, it also shattered the economic doctrines ruling at the time which celebrated the economic system s self-correcting and equilibrating forces. Bad policies made the Depression worse than necessary but favourable policies rather than endogenous equilibrating forces ended the Depression. However, although the 1930s witnessed the birth of modern macro economic theory, expansionary fiscal policy did not matter much or at all in the economic recovery. Monetary policy and exchange rate policy mattered a lot, however. The end of the contraction and the beginning of the recovery from the depression started in Europe when the UK and Scandinavia (and about 20 other nations) left gold and devalued in September It is true that this decision was taken not so much out of a clear view of policy priorities but because the Bank of England and the British Government did not expect that they could stem the speculative attacks against the pound. The UK s problem was that it had been lending to other nations on a long term basis and had got some of its assets frozen by Germany s debt moratorium, while a significant proportion of its liabilities were in short-term foreign borrowing. Its international reserves had been reduced during the short but costly defence of the pound s adherence to the gold standard, and because the UK s traditional export markets in Latin America and the Empire had been hit by the fall in food and raw-material prices before and during the Depression. The UK used to have an export surplus with these areas. Many of the UK s trading partners, such as Argentina and Australia, left gold and devalued before the UK. What then were the links between recovery and exchange rate policy for the UK and other nations in the early devaluing nations? 1 This note draws heavily on Barry Eichengreen and Jeffrey Sachs, Exchange Rates and Economic Recovery in the 1930s, chapter 9 in B. Eichengreen (ed.), Elusive Stability, Essays in the History of International Finance, Cambridge: Cambridge University Press, Christina D. Romer, What Ended the Great Depression? Journal of Economic History, 52, 4, 1992, pp

2 1. Monetary policy no longer needed to be used to defend an overvalued exchange rate, so by 1932 interest rates were permitted to fall. That is, monetary policy could now be used for domestic expansionary purposes. 2. Devaluation ended the ruling deflationary expectations and prices started to increase after falling for years. The combination of falling nominal interest rates and inflation reduced real interest rates considerably. Given two digit deflation early in the depression, the fall in real interest rates was truly significant and stimulated investment. 3. Inflation also reduced product wages 2 and real wages (for those who were not unemployed). During the depression real wages had in fact increased despite increasing unemployment. Nominal wages fell but less than prices. Now the situation was reversed. Nominal wages did not change much but prices increased. This mechanism is well described by data from Sweden in Figure 1. Changes in the consumer price index rather than nominal wages are driving real wages and the speed of the reaction was fast. 2 The product wage is the nominal wage in industry j deflated by the price of the product from industry j. 2

3 Figure 1. Shocks and outcome in the industrial sector relative to 1930=100, yearly averages. Source: Fregert, Klas; The Great Depression in Sweden as a Wage Coordination Failure, European Review of Economic History, Vol. 4, (Dec. 2000), pp Devaluation and reduced product wages stimulated industrial production in Europe as demonstrated by Figures 2-4. These figures describe performance in economic indicators between 1929 (= 100) and The straight lines are linear regressions. In Figure 2 the interpretation of the positive slope of the regression line is that economies remaining on the Gold Standard, such as 3

4 France and the Netherlands, experienced a fast increase in real wages, while the real wages increase was lower in the early-devaluing nations, such as Sweden and Denmark. Figure 2. Changes in exchange rates and real wages, Source: Eichengreen, Barry & Jeffrey Sachs; Exchange Rates and Economic Recovery in the 1930s, in B. Eichengreen (ed.) Elusive Stability, Essays in the History of International Finance, , Cambridge: Cambridge University Press, 1990, pp Devaluing nations also managed to halt the decline in exports although the recovery was slight. The interpretation of the linear regression in Figure 3 is that if a country stuck to the 1929 nominal exchange rate (1929 = 100) then a sharp fall in exports would be expected, that is, the export index is much below 1929 levels equal to 100. However, it must be remembered that the barriers to trade that were erected after 1930 were not giving nations much scope for export expansion and export 4

5 led growth. Although export led growth did not bring much relief, industrial production was clearly affected by devaluation for two reasons. Figure 3. Changes in exchange rates and export volumes, Source: Same as for Figure 2. Devaluation opened up opportunities for monetary expansion and improved the competitiveness of domestic industry relative to foreign competition, which is demonstrated by Figure 4. 5

6 Figure 4. Changes in real wages and industrial production, Source: Same as for Figure 2. Devaluation is often described as a beggar-thy-neighbour policy, that is a policy by which one nation gains to the disadvantage of other nations. For example, domestic industry expands only by reducing imports. In the present context that view overlooks the fact that devaluation plus leaving the gold standard opens up monetary autonomy. An expansion of the domestic economy will, all other things equal, increase demand for imports. Furthermore, when large economies like the US, theuk and Germany take the lead in the march towards protectionism, the best thing small nations can do is to give domestic policy targets highest priority. The US Recovery There were no signs of recovery during the Republican administration under president Hoover. President Roosevelt came to office in 1933 and new hope was born. Roosevelt introduced a series 6

7 of federal programmes under the label New Deal to stimulate recovery. These programmes certainly helped to form a more optimistic public mood but fiscal policy did little to help the stagnating economy. The Roosevelt administration understood that deflation was a major problem and abandoned the Gold Standard, leaving France the only major economy keeping its currency linked to gold. The dollar was floating and depreciated against other currencies and against gold, that is, the dollar price of gold increased. The revaluation of gold stimulated an immediate increase in the flows of gold into the US at a yearly rate of increase of about 15 per cent. However, unlike in the 1920s when gold inflows were sterilized, inflows were now permitted to affect the money supply positively. 3 The transition mechanism between money supply and recovery is inflationary expectations and their effect on real interest rates: If deflationary expectations are replaced by inflationary expectations then expected real interest rates, that is nominal interest rates corrected for expected inflation, will fall. Investors and consumers care about real rather than nominal interest rates. It can be shown that there is a strong correlation between real interest rates and investment and consumption of durable consumer goods as indicated by Figures 5 and 6. You can read the real interest rates on the right hand scale and changes in investments and consumption on the left hand scale. Since nominal interest rates were close to zero, inflationary expectations easily made real rates negative: an investor s paradise. Figure 5. Real fixed investment and ex ante real rates, Part of the inflow of gold was probably a flight from the political uncertainty in Europe. 7

8 Source: Romer, Christina D.; What Ended the Great Depression? The Journal of Economic History, Vol. 52, No. 4 (Dec. 1992), pp Figure 6. Real consumer expenditures on durable goods and ex ante real rates, Source: Romer, Christina D.; What Ended the Great Depression? The Journal of Economic History, Vol. 52, No. 4 (Dec. 1992), pp But how do we know that it was monetary policy rather than fiscal policy that dragged the US economy out of the depression. One way of approaching the problem is to do counter-factual history. We ask the following question: What would economic growth be like if the Roosevelt administration had pursued normal monetary policy, that is, if money supply grew at a rate typical of the pre-depression times. You also need a monetary policy multiplier for this exercise, estimated as 0.823, which implies a money supply growth rate 1 per cent above normal rates leads to a GDP growth rate that is per cent higher than normal. 4 The experiment on the impact of fiscal policy is constructed in an analogous way, although the fiscal multiplier differs, of course. Since there was not a consistent consolidated fiscal deficit in the 1930s we would not expect a strong effect from fiscal policy. 4 The multipliers are estimated for two periods, and , which were considered as having independent policy initiatives. However the results are fairly robust to a reasonable range in the multipliers. See Romer, op.cit. pp

9 Figure 7. Actual output and output under normal fiscal policy, Source: Romer, Christina D.; What Ended the Great Depression? The Journal of Economic History, Vol. 52, No. 4 (Dec. 1992), pp Figure 8. Actual output and output under normal monetary policy, Source: Romer, Christina D.; What Ended the Great Depression? The Journal of Economic History, Vol. 52, No. 4 (Dec. 1992), pp Figures 7 and 8 respectively trace the impact of fiscal and monetary policies, respectively, as compared to normal policy. In the case of fiscal policy it did not deviate from normal policy despite the depression, that is, there were no unusual fiscal policies implemented in the 1930 s to help the economy recover. However, monetary policy was unusual, generating a large difference between, Actual Real GNP and GNP Under Normal Monetary Policy. 9

10 So what are the lessons: economic policy matters, money is not neutral, economies are not selfregulating machines, moderate deflation is more dangerous than moderate inflation. 10