Europe Between the Wars:the Economics of the

1920s and 1930s

Off of Gold• At the beginning of World War I, there is a

panic----people run to the banks demand gold in all countries & countries at war have gold being shipped out.

• Central banks begin to run out of gold• All belligerents go off the Gold Standard but they

promise to return to the prewar parity• Refuse to convert notes into gold----so Bank of

England/Bank of France/Reichsbank notes are “fiat money”

• Money creation by printing more currency and open market purchases of bonds

• Currencies are allowed to “float.” The market determines their value not gold.

$/£

Quantity of £s

$4.86

Supply

Demand

$3.20

Depreciation of the British pound sterling 1914-1919

1913 1919

Why do countries promise to return to the “prewar parity” (UK: £1 = US$4.86)

• Why was the gold standard appropriate in the 19th century?

• Long-term price stability, financial stability

• Fiscal discipline of balanced budgets.

• Reassures holders of debt they will be repaid in full.

• Return to gold requires substantial deflation to allow return to prewar parity

The Hopeless Case:

Germany after the

Hyperinflation 1923-1924

Germany: the Hopeless CaseNo Return to Gold: “Start-Over”

• Hyperinflation ends in 1923• Value of all nominal liabilities and assets wiped out---

savings account to mortgages.• New currency in November 1923 Rentenmark replaces

the Reichsmark, converted at 100 trillion to one, losing 11 zeros. $1 = RM 420,000,000,000

• Germany goes back on gold on a new parity where $1 = RM 4.2

• Strengthened by Dawes loan of US$800 million to finance Reparations.

• Reichsbanks begins operation with ¾ gold and ¼ foreign exchange reserves.

Germany’s Recovery Begins

• New Reichsbank under Hjalmar Schacht sets a tight monetary policy

• High interest rates so that Germans not tempted to flee new currency and foreign capital is attracted.

• Germany recovery begins in 1924.

• But trust in new government is weak

But……

• No other country has the excuse that they had a hyperinflation that made their currency worthless, wiping out the value of all bonds, savings accounts, and all debts…….

• So others have tough decisions to make…….

Britain after World War I• Britain at outset of World War I was committed to return to gold

at prewar parity. • The British had experience in Napoleonic wars—Britain had

gone off gold in 1797 and returned in 1821. Long-term interest rates had stayed low because public believed that inflation would be reversed. Faith that government would do it again.

• [Example: £100 face value consol = P, coupon C = £3 per year and i = yield. P = C/i £100 = £3/.03. If price level doubles that means that in real terms the value of the coupon is halved £1.50. Price level must drop to restore yield.]

• Pressure from the City of London. Desire to restore London’s prewar position as the world’s financial center.

• The official Cunliffe Committee Report in 1918 accepts idea of return to prewar par.

• John Maynard Keynes criticizes a return to par—deflation too costly for anyone with a contract---nominal wages must be cut.

No Immediate Return

• In 1920, £1 = $3.40, the market’s evaluation.

• But by 1923 £1 = $4.70 after flight of capital from Germany and continent during hyperinflation and French-Belgian occupation of the Ruhr.

• Labor government discusses capital levy---capital flight and pound sinks to $4.30.

In April 1925, the government decides that it is time to move back to the gold standard. Winston Churchill, Chancellor or the Exchequer, strongly behind move.

Bank of England raises interest rates to attract foreign capital and deflate economy.

Britain’s Dilemma• 1913 £1 = $4.86 or £0.206 = $1• Pound depreciates so £1 = $3.20 at low point.• Government begins to contract money supply deflation and

appreciation of pound• In 1925, exchange rate seem close enough and government

decides to return to prewar parity of £1 = $4.86, but there was not enough deflation

• E = 0.206 £/$ [1/E = 4.86$/£]• But at this time one ton of steel costs $100 in the U.S. and £22.6 in

the U.K. so at £0.206 = $1 then, the U.S. steel costs in Britain ($100)(.206£/$) = £20.6

• Compare prices? British steel £22.6, US steel £20.6• £ is overvalued, British goods not competitive so:• IM > EX => Balance of Payments Deficit => gold reserves drop• Response of Bank of England by the “rules of the game” is to raise

interest rates. Result deflation. • Pound overvalued by 10%.

British Consternation!• Under a classical gold standard and playing by the

“rules of the game” deflation should lower prices and restore balance of trade. IM = EX.

• However, Surprise!• Prices and wages prove to be “sticky,” the economy

does not behave by 19th century rules!!!• In 19th century, when prices were falling, many

workers had contracts where they agreed to accept lower wages. Especially in the coal industry, as well as others.

• After war---and considerable sacrifice---workers resist.

The General Strike

• In 1925 the mine-owners announced that they intended to reduce the miner's wages. Trade Union Congress promises to support miners.

• The Conservative Government does not back mine-owners and decided to intervene, providing money to bring the miners' wages back to their previous level. The Prime Minister stated that this subsidy to the miners' wages would only last 9 months.

• A Royal Commission investigates. It recommended that the industry be reorganized and the Government subsidy be withdrawn and miners' wages be reduced.

• Miners refused---they are locked out of mines by mine-owners. TUC declares a general strike.

General Strike 1926: armed escort for food convoys

• The subsidy expired in May 1926, and the Tories led by Stanley Baldwin and Winston Churchill refused to renew it.

• Mine owners slashed wages and extended the working day. The miners’ union resisted and asked the TUC for support. The General Strike was the result.

• Eventually TUC gives up

But British wages and prices don’t fall enough

• Coal, steel, shipbuilding and textiles, the 19th mainstays of British industry are depressed industries.

• Unemployment concentrated in North of England, Wales and Scotland.

• Loss of export markets during war• Priced out of market by return to gold at prewar

part.• During 1920s, British unemployment remains

above 10%, though compensated by generous unemployment benefits.

• British economy performs very poorly, low growth and high unemployment 1925-1929.

British Performance

France Comes Close to Disaster• France continues to be dependent on short-term

borrowing to cover its budget deficit---that persists after the war.

• By 1923 Budget Deficit = 31% of spending.• Government unable to persuade Parliament to raise

taxes---hope that Germany will pay reparations and solve the problem of the debt.

• New short-term bonds issued, but public lacks confidence---result high interest rates.– Bank of France buys bonds to keep rates low, adds to money

supply and to inflation, rates continue to rise– Capital flight. Fearful of inflation, investors send money abroad,

worsening balance of payments deficit.

• The Franc depreciates: 1913 25FF = £1, Spring 1926 90FF = £1, then May 1926 170 FF = £

• Fears of a French Hyperinflation.

“Franc Poincaré” • In the crisis, Raymond Poincaré

becomes prime minister and finance minister.

• He lowers income taxes to gain confidence of wealthy and proposes new general taxes. Capital flight ends.

• Franc recovers slowly• Decision NOT to force a deflation and

NOT to return to prewar parity of 25FF = £1 and 5FF to US$1.

• Belief that deflation would ruin French industry and agriculture.

• New parity £1 = 124 FF

France’s Belles Anneés• 1913 £1 = 25FF or 5FF = $1• Postwar depreciation of franc with inflation • In 1926, French government sets the new parity of £1 = 124 FF• E = 124 FF/£ • But at this time one sewing machine costs £100 in the U.K. and

11,000 FF in France, so at £1 = 124FF then, the British sewing machine costs in France (£100)(124FF/£) = 12,400 FF

• Compare prices in France? British sewing machine is 12,400FF, French sewing machine is 11,000 FF

• Franc is undervalued, French goods very competitive in France and Britain:

• France: IM < EX => Balance of Payments Surplus => gold reserves rise

• Response of Bank of France by the “rules of the game” is to lower interest rates but not enough. Result? Expansion and little inflation.

• Rapid growth and falling unemployment---an economic boom.• French gold reserves swell.

Italy—Capricious Dictator• Postwar poor economic

performance. Lira falls in value from 25L = £1 to 150L = £1, the recovers slightly

• Democracy is subverted in Italy when Mussolini marches on Rome in 1922.

• He wants to see a “strong” lira—a sign of Italy’s renewed greatness.

• His goal is the “cuota novanta” or the quotation of 90 lire to the pound sterling.

• In 1926, with a loan from the U.S. banks, the Banca d’Italia has enough reserves and lire is pegged at 90 L = £1

Italy’s Stagnation• 1913 £1 = 25L or 5L = $1• Postwar depreciation of the lira with inflation• In 1926, Italian government sets the new parity of £1 = 90 lire• E = 90 L/£ • But at this time, one hundred hats costs £100 in the U.K. and

10,000 L in Italy, so at £1 = 90 L then, the British hats cost in Italy (£100)(90L/£) = 9,000 L

• Compare prices in Italy? British hats cost 9,000L, Italian hats cost 10,000 L

• Lira is overvalued, Italian goods are not competitive in Italy or in other countries. :

• Italy: IM > EX => Balance of Payments Deficit => gold reserves fall• Response of Bank of Italy by the “rules of the game” is to raise

interest rates. • Result? • Slow growth and high unemployment.

Spain---the overvalued peseta• General Miguel Primo de la

Rivera overthrows parliamentary democracy in Spain and rules as military dictator 1923-1930.

• Sets the peseta at an overvalued parity, so that it is “strong.”

• Result?

Comparative Policies

Comparative Wage Inflation—and

Competitiveness

Comparative Performance 1919-1929

• Total Increase in GDP, 1919-1929• UK 11% < Italy 18% < Germany 68% < France 79%• Interest Rates in 1928• UK 4.5% Italy 7%, Germany 7%, France 3.5%

• US growth over the decade 41%.• Huge Imbalances at the beginning—much bigger than

adjustments pre-1913.• Adjustments are incomplete by 1929• Thus, the interwar gold standard (1924-1936) is a fragile

system---unlike the classical gold standard of 1870-1913

Uneven Recovery to 1929Real GDP

UK France Germany Italy Neth. USA

1913 100 100 100 100 100 100

1919 101 75 72 111 112 116

1929 112 134 121 131 177 163

If real growth rate 2% or 3%, then potential GDP was 112 or 119 in 1919 or 140 and 165 in 1929

What Turns a Recession into a Great Depression?

1. Structure of the System2. Shocks to the System

• There were important shocks to the world system, beginning in 1929.

• But there were some conditions that predisposed world economy to a huge decline.

• Eichengreen points out four structural factors– 1.?– 2?– 3?– 4?

Eichengreen (1992):Four Contributing Structural Factors

1. Changes in the Composition of Production1. Britain: decline of traditional iron and steel, coal textiles and

shipbuilding (No. England & Wales and Scotland), rise of chemicals, electrical engineering, cars (Southern England). High regional unemployment.

2. U.S. Rise of consumer durables. Consumer durables and investment are very sensitive to the business cycle. Problem of installment payments—higher real payments, repossession, no credit for lost payments.

2. Operation of labor markets1. Inflexible wages

1. Rise of Unions---UK, Germany….but these not very comprehensive after World War I.

2. Internal Labor markets—personnel departments—layoffs not wage reductions. But only in the U.S.

2. Unemployment Benefits---relatively high in the UK and some work disincentive but not enough to fully explain high unemployment.

U.S. (Consumption 80-90%)

Eichengreen (1992):Four Contributing Structural Factors

3. Operation of International Monetary System—failure to treat gold standard as a collective good

1. Domestic political constraints—lack of willingness to make adjustments

2. International disputes—reparations3. Incompatible behavior—violation of the “rules of the

game”4. Pattern of International Settlements.

1. The U.S replaces (partly) the U.K. as center of world capital markets.

2. Countries operate on smaller gold reserves and “Hot” Money flows makes adjustment more difficult.

Gold Reserves of Central Banks: Results of Over and Undervaluation of Currencies

Percentage Shares1913 1925 1929

USA 26 44 38

UK 3 8 7

France 14 8 16

Germany 6 3 5

Italy 6 3 2

Shocks? 1. Tight Monetary Policy or 2. Golden Fetters? 3. Tariffs and Quotas?

• Golden Fetters? A large deflationary shock or financial crisis starts forces a country to defend gold standard by deflation. Maintain Gold Standard Conflicts with Goal of Full Employment

• Tight Monetary Policy? Was the U.S. monetary policy too tight by choice---trying to deflate the bubble on Wall Street and then preserve the gold reserve. Stopping Bubble Conflicts with Full Employment.

• Trade Policies---Beggar-Thy-Neighbor policies starting with the Smoot Hawley Tariff in the U.S. – First Round---You gain and your trading partner loses– Second Round---You lose…and the rounds continue

UK France Germany Italy Neth. USA

1913 100 100 100 100 100 100

1919 101 75 72 111 112 116

1929 112 134 121 131 177 163

1933 109 123 108 127 164 115

1939 134 139 183 162 195 165

The Great DepressionReal GDP 1913=100

If real growth rate 2% or 3%, then potential GDP was 112 or 119 in 1919 or 140 and 165 in 1929 or 170 and 222 in 1939.

How Did Events Unfold?

• The Countries with overvalued currencies---France, Netherlands, Belgium, Switzerland---gain gold reserves. Inflationary pressure for them and deflationary pressure on other countries.

• Asymmetric responses.• Violation of the “Rules of the Game.” France etc.

try to sterilize gold inflows so it won’t have full inflationary effects.

• U.K., Italy, and other countries forced to tighten monetary policy raise interest rates.

Tighter Monetary Policy

• In response to gold outflows, U.S. raises discount rate in 1928 from 3 ½ to 5%. Appropriate as U.S. is a booming economy.

• U.K. finds it difficult to raise rates with its depressed economy, high unemployment. A conflict between internal and external goals. Continued loss of reserves. Briefly gets the U.S. to lower its rates to prevent gold losses.

U.S. Monetary Policy

U.S. Stock Market Boom• Huge rise in the U.S. stock market, March 1929. Big

boom in high tech stocks. People borrow to invest. New investors flood the market.

• Other lending dries up. Foreign loans to Germany, Austria and Latin America cease----their investment falls and they move into recession in 1929.

• Market booming. In July 1929, Federal Reserve raises the discount rate from 5 to 6%.

• But U.S. economy beginning to slow. Result is beginning of sharp recession in September.

• Stock market crashes in October 1929.• Federal Reserve Bank of New York eases monetary

policy to save financial system but once crisis is over the Federal Reserve Board forces a return to tight money.

Crisis in Austria, 1931• Austria owes reparations and borrows heavily from U.S. and

France.• 1928-1929 ends capital inflows--cannot borrow anymore.• Largest bank, Credit Anstalt borrowed from abroad to lend at

home. Funds withdrawn, cuts lending. Bad loans wipe out capital and it loses deposits.

• Central bank steps in to guarantee deposits• Discovery of secret plans for Austrian customs union with

Germany---French withdraw their investments.• Dual problem---1. run on the currency and 2. run on the

banks.• Policy Dilemma---Central bank has only one tool---if it

lowers interest rate to help domestic crisis, the foreign crisis worsens, if it raises interest rate to stop external crisis, economy sinks.

• Reaction: ends Gold standard with capital controls and blocked trading.

• Tight monetary policy continues, hope to return to Gold.• Economy continues to decline

Crisis in Germany, 1931• New American and other foreign investment ceases.

German growth slows.• Germany’s short-term foreign capital = 3 times its gold

reserves in Reichsbank. Confidence is essential.• Reichsbank raises interest rates.• Many firms fail, including Nordwolle, its insolvency

threatens solvency of banks.• Germany faced with a dual problem---1. run on the

banks and 2. a run on its currency. Dilemma—raises or lower interest rate?

• Declaration of bank holiday and exchange and capital controls = Germany abandons the Gold Standard

• Tight money continues, Germany hopes to return to Gold and stay at 1924 parity

• Begins a Deflationary Policy---Economy continues to decline

Gold Reserves of Central Banks Percentage Shares

1913 1925 1929 1931 1935

USA 26 44 38 36 45

UK 3 8 7 5 7

France 14 8 16 24 20

Germany 6 3 5 2 1

Italy 6 3 3 3 2

Next Crisis? Britain 1931• Country sliding into a recession. Large trade deficit.

Payments on debt from Germany, Austria and Hungary are not made in 1931. Latin America defaults on debt. Speculators withdraw funds. Loses Gold.

• July 1931, Bank of England raises discount rate by 2 points. Shouldn’t this attract foreign capital and improve competitiveness?

• Unemployment already 20%, economy slides further and NO increased confidence, funds continue to be withdrawn.

• Speculative attack on the pound• Britain leaves gold September 1931.• Unlike Germany and Austria---UK allows its currency, the

pound, to float and to lower interest rates and follow an easy money policy. No promise to return to $4.86

• Bank of England lowers interest rates• Pound sterling depreciates by a third relative to dollar. Exports

competitive• Economy begins to rebound

U.S. Depression• Tight monetary policy continues through 1930 and

onwards---high real rates of interest. Consumption and investment drop.

• Smoot-Hawley Tariff 1929---highest ever U.S. tariff sets off retaliation---world trade sinks.

• Tight Money aims to preserve gold reserves to stay on the Gold Standard

• Three Banking Panics: 1930, 1931, and 1933 result in reduction in money multiplier: Monetary and financial collapse.

• GDP falls 25% and unemployment rises to 20% in 1933.• Huge loss of gold reserves.• March 1933---new Roosevelt administration. Bank

holiday and suspend convertibility of dollar into gold—off the Gold Standard

• Monetary policy finally eased

France and the “Gold Bloc”(Belgium, Netherlands and Switzerland)

• 1931 when other countries in crisis France is strong. Huge gold reserves and export surplus.

• Britain, U.S. and other countries devalue or allow currencies to depreciate, France’s competitive advantage decreases.

• 1933 France is in recession, with a budget deficit and a trade deficit.

• Strict adherence to gold---slashes spending and raises taxes- deflationary pressure. Economy contracts.

• Finally France and the Gold Bloc forced off gold in 1936.

General Worldwide

Deflationary Policies.

Can you pick out:

Which countries

abandon the Gold

Standard and When?

When do policies shift?

Late 1930s—an anemic recovery

• By 1936, all countries have abandoned the gold standard.

• 1936, U.K., France and the U.S. create the Tripartite Agreement where they informally agree not to pursue more devaluations and to stop any more limitations on free trade.

• Change prefigures International Monetary Fund, and the World Trade Organization (WTO---formerly GATT) after World War II

• But less, than full recovery.

UK France Germany Italy Neth. USA

1913 100 100 100 100 100 100

1919 101 75 72 111 112 116

1929 112 134 121 131 177 163

1933 109 123 108 127 164 115

1939 134 139 183 162 195 165

The Great DepressionReal GDP 1913=100

If real growth rate 2% or 3%, then potential GDP was 112 or 119 in 1919

Policy Legacy

• Problems generated by World War I were not successfully resolved.

• Weak system hit by hard multiple shocks.

• 1930s a “lost decade”

• Failure of “laissez-faire,” “gold standard” and “balanced budgets”

• Distrust of free market policies

• Distrust of globalization

Reaction• Socialism and Government Intervention arises in

all countries---UK, France, Germany, Italy, US etc.

• Government control or regulation of industries----prices, entry and production—the end of laissez-faire.

• Deficit spending. Fiscal policy to stimulate the economy. End of balanced budgets.

• Off the Gold Standard. Permits Central Banks discretion to operate monetary policy. Focus on output and employment not the gold reserves. Inflationary bias to policy.

• End of Globalization. World Trade shrinks. End of Immigration. Capital Controls—ends international capital movements.