Topic 8 : The Interwar Globalization Backlash Department of Economics University of Warwick March, 2014
We focus on the monetarist view : It was the Fed s policy mistake ignoring the importance of money The U.S. economy during the 1920 s : the roaring twenties - industrial production grew 40% from 1920-1929 - half of world industrial output produced in U.S. The Fed believed the economy was overheated (especially the stock market)
What happens in an overheated economy? inflation speculative bubble If bubble is popped, economy faces dire consequences So price stability is one of the main goals of economic authorities. Bubble : Price should only reflect the fundamental value but in the case of bubble it increases due to speculative reasons.
1 On one hand the Fed implemented contractionary monetary policy in order to maintain price stability 2 On the other, there was Great stock market crash in Oct. 1929 but the Fed did not act as the lender of last resort As a result of ➀+➁, money supply and price level fell by 35% and 33%, respectively. As a result of ➁, 1/3 of banks went bankrupt. Also these bank failures further reduced money supply. How?
Usually money supply is created through money multiplier effect. In a very narrow sense, money supply = notes and coins + bank deposits Let r = reserve ratio the minimum fraction of customer deposits and notes that each commercial bank must hold (rather than lend out) as reserves.
Suppose newly minted 100 is deposited in bank A. Then, for bank A { r 100 100 = (1 r) 100 for reserve requirement for profitable activity In fact, suppose that it decides to deposit this in bank B Then, for bank B { r(1 r)100 (1 r)100 = (1 r) 2 100 for reserve requirement for profitable activity And this can go on and on.
So initially there is 100 which is deposited at bank A, but there is additional deposit of (1 r)100 at bank B and so on. The amount of money created from 100 is 100 + 100(1 r) + 100(1 r) 2 + = 1 r 100 1 r is called the multiplier
Therefore in order for money supply to be amplified through the multiplier effect, it is essential to have well-functioning banking systems and substantial number of banks. But with huge banking failures, this mechanism could not work properly, contributing further decline in money supply.
So summing up, Contractionary monetary policy + massive banking failures Money supply declined hugely Deflation and interest rate Consumption and investment Output massively
Also, Stock market crash + massive banking failures Wealth declined hugely Consumption and investment Output massively
Two major mistakes by the Fed, 1 Decision to conduct contractionary monetary policy (even after the crisis) 2 Decision not to bail-out failing banks
3. Why was international co-ordination of monetary policy desirable but unattainable? The essential criteria for the Gold Standard to work well are 1 to hold certain amount of gold reserve to back its currency usually 40% of notes issued think of today s countries having US $ reserve 2 in order to achieve ➀ it is important to have co-ordination of monetary policy among the members. Let s look at ➁ more in details
3. Why was international co-ordination of monetary policy desirable but unattainable? It should happen at the same time that countries { losing gold money supply deflation + interest rate gaining gold money supply inflation + interest rate So that gold flows back to countries who lose gold initially from countries who gain initially. And the equilibrium can be restored.
3. Why was international co-ordination of monetary policy desirable but unattainable? During 1870-1913, this kind of co-ordination among countries was functioning very smoothly But in early 1930, countries gaining gold like the U.S. implemented contractionary, instead of expansionary, monetary policy This put further deflationary pressure on gold-losing countries as they had to conduct stronger contractionary monetary policy in order to regain gold. Because of this the world economy was under severe deflationary pressure.
2. Why did economic policies become more protectionist in the 1930s? As a result of this (what we discussed in question 3) the Gold Standard collapsed by early 1930 s Consequently, countries began to implement beggar-thy-neighbour policies which include competitive devaluation tariff and quota These policies were retaliatory in nature, thus the world trade volume collapsed leading to the trade bust.
4. Why was there so much default on sovereign debt in the 1930s? Concentrated to Latin America as the region s economy relied heavily on exports to the U.S. and borrowed heavily from the U.S. The protectionism in the U.S. weakened the terms of trade and high interest rate increased the debt payment Also default was encouraged as it was perceived as a commercial risk run by private bondholders.
9. Why was there no repeat of the Great Depression in 2008-10? Different policy responses from the early 1930 s expansionary monetary policy and aggressive interest rate cuts preventing bank failures constraint of the Gold Standard absent In other words, more and proper interventions by central banks and national governments
8. What lessons for today should Eurozone countries take from the 1930s? PIIGS countries are facing sovereign debt problems. Devalue and default can be one possible solution that can be taken from 1930 s experience But this can jeopardize the whole European (or even world) banking system.