Europe in the World Economy: An Economic HistoryThe Recovery 1931- 1939

Slides by Karl Gunnar Persson and Paul Sharp

Last time

• We looked at the impact of the Great Depression on the American economy and people.

• We discussed briefly theories that have been put forward for the origins of the Great Depression.

• We focussed on explanations from the demand side of the economy:• Consumption• Investment• Government consumption• Net exports

This time

• We look at the international impact of the Great Depression, particularly in Europe.

• We start by looking at the years running up to the Depression.

• We then look at the impact of the Depression.• We then answer the central question: Why did

some countries recover faster than others?

• We focus in particular on monetary policy and especially the role of the gold standard.

• Many economists (starting with Eichengreen) have given the gold standard primary responsibility for the length and severity of the Great Depression.

Putting the interwar experience into perspective

European Growth

GDP Population GDP/capita

1890-1994 2.4 0.6 1.8

1890-1913 2.2 0.7 1.4

1913-1950 1.4 0.5 0.9

1950-1973 4.8 0.8 4.0

1973-1994 2.1 0.4 1.7

Source: Feinstein, p. 7

Putting European growth into perspective

Real GDP Growth

Europe USA Canada Japan

1890-1994 1.8 1.8 2.0 2.9

1890-1913 1.4 2.0 2.8 1.4

1913-1950 0.9 1.4 1.4 0.9

1950-1973 4.0 2.9 2.9 8.0

1973-1994 1.7 1.4 1.4 2.8

Source: Feinstein, p. 9

Why did Europe do so badly in the 1913-50 period?

• War! Two world wars largely fought in Europe.

Results:• Structural imbalances• Lack of leadership• Absence of international co-operation• Old-fashioned political and financial ideologies

The First World War

• First “total war”: massive increase in production, conscription etc.

• Destruction of infrastructure.• Lost export markets.• Rise in public debts.• Gold standard suspended.

The post-war settlements

• New political map of Europe disrupted old trade patterns.

• Increased competition from new industrializers.

• Versailles Treaty held Germany responsible for the war. Saddled Germany with large reparations.

• Political uncertainty made governments willing to spend but it was hard to tax people impoverished by the war.

Inflation and hyperinflationCPI 1918-26 (1914=100)

1918 1920 1922 1924 1926

Austria 1163 5115 263938 86 103

Germany 304 990 14602 128 141

Belgium 1434 - 340 469 604

Finland 633 889 1033 1055 1078

Italy 289 467 467 481 618

France 213 371 315 395 560

Norway 253 300 231 239 206

Sweden 219 269 198 174 173

Switzerland 204 224 164 169 162

UK 200 248 181 176 171

Denmark 182 261 200 216 184

Netherlands

162 194 149 145 138

Germany for 1923: 15,437,000,000,000

Source: Feinstein, p. 39

Stabilization and return to gold 1922-29

Year of restoration New parity as % of pre-war

Austria 1922 0.00007

Germany 1923 0.0000000001

Belgium 1926 14.5

Finland 1924 13.0

Italy 1926 27.3

France 1926 20.3

Norway 1928 100

Sweden 1922 100

Switzerland 1924 100

UK 1925 100

Denmark 1926 100

Netherlands 1924 100

Source: Feinstein, p. 46

Rules of the game

• UK and Scandinavia needed to deflate because domestic currencies overvalued in PPP terms.

• In UK: collapse of export industries, downward pressure on wages, employment, etc.

• “Late stabilizers” enjoyed brief boost to exports due to undervalued currencies.

• Overvalued = domestic currency buys more goods abroad than at home at the fixed nominal exchange rate.

• The concept of over and undervalued is always relative to Purchasing power parity.

Capital flows

• France stabilized at a reduced parity…• … and sterilized gold inflows.• Concerned about renewed inflation.• Exacerbated by low levels of foreign investment

(investors nervous after Russian losses).• US also sterilized gold inflows.• US and French gold holding reached 70% of world

total!• Remember: Lack of coordination a big problem!

Industrial growth in deflationary and inflationary nations in Europe in the 1920’s.

The Great Depression

• European economies had higher trade/income ratios than the US, so hurt more by worldwide collapse of trade.

• The gold standard constrained monetary policy.• Germany squeezed by reparations and large foreign

debt.• France did relatively well in first years due to large

international reserves.• Financial system disintegrated in Austria and

Germany, partly because central banks could not act as “lender of last resort”.

• High unemployment.• Trade blocs and protectionism.• Regulated capital mobility.

Unemployment during the Great Depression

Compare to pre-WW1 optimism

There is now no possibility of reaching a normal level of production in the near future. Our efforts are directed towards the attainment of more limited hopes. Can we prevent an almost complete collapse of the financial structure of modern capitalism? With no financial leadership left in the world and profound intellectual error as to causes and cures prevailing in the responsible seats of power, one begins to wonder and to doubt.

- Keynes (1932)

Collapse of the gold standard

• Germany introduces capital control and debt moratorium in July 1931.

• Pressure on sterling.• Collapse of export markets.• UK had tried to continue

exporting capital to developing countries, but could only do so by borrowing.

• Reserves inadequate to cover liabilities.

• Loss of confidence causes UK to abandon gold in September 1931.

• Germany kept to orthodox monetary policy.

• UK turned expansionary.• Many countries followed UK.

Bad economic policies helped Hitler to power.

By mid 1931 Germany had introduced capital controls and could practice an independent expansionary monetary policy. Reichsbank did not and created more unemployment and Adolf Hitler.

The United States

• Hoover administration stuck to economic orthodoxy.• Roosevelt administration from 1933 recognized dangers of

deflation and left gold standard.• Under no market pressure to do so! Break with economic

orthodoxy.• World Economic Conference 1933: “The sound internal

economic situation of a nation is a greater factor in its well-being than the price of its currency.”

• In Germany a similar break with tradition only came with the Nazis.

• One of the worst consequences of the Great Depression.

The gold bloc

• Response to Roosevelt’s message: Commitment by France, Belgium, Holland, Switzerland, Italy and Poland to maintain gold standard.

• Still constrained to follow deflationary policies.• Unemployment remained high.• French government elected with promise not to devalue.• Needed to negotiate internationally to avoid competitive

devaluations.• 1936 Tripartite Agreement with US and UK allowed France

to devalue.

Why devaluation marks beginning of recovery!

• Monetary policy no-longer subservient to maintaining exchange rate.

• Devaluation ended deflationary expectations, prices start to increase.

• Falling interest rates and rising prices led to increase in investment.

• Inflation also reduced real wages, helping industrial output.• Decline in exports halted.• Competitiveness of domestic industry improved.

• Remember: Recovery begins in 1931!

Recovery in the US

• Revaluation of gold led to immediate increase in flows of gold into US.

• Gold flows were not sterilized, but allowed to increase money supply.

• The impact on consumption and investment through the real interest rate is clear. (Real i.r. is nominal controlled for inflation)

How do we know it was monetary policy that saved the US economy?

•Christina Romer’s counterfactual history.

•Note that fiscal policy was “normal” in the 1930s, whereas monetary policy was unusual.

•It turns out that this monetary policy accounts for a large part of the growth in real GNP.

Summary: Compare Britain and France

• These countries illustrate well the varying responses to the Great Depression.

• France rejoined gold at reduced parity, UK at original parity.

• France did relatively well in the 1920s and was not initially too badly hit by the Great Depression.

• France left gold late, UK early.• UK recovered much earlier from the Great

Depression.

What can we learn from the recovery?

• Note the power of economic orthodoxy…

• … and the importance of economic policy!

• Money is not neutral!• Moderate deflation is more dangerous

than moderate inflation!

References

http://www.english.uiuc.edu/maps/depression/about.htmFeinstein, C.H., Temin, P. & Toniolo, G. (1997), The European

Economy Between the Wars.

And of course the following is compulsory reading!Persson, K.G., A Note on the Economic Recovery in the 1930s.

Conclusion

• Growth and prosperity achieved in periods of multilateral trade, regulated exchange rate flexibility and financial co-operation.

• Economic hardship in times of trade wars, financial rigidity.

• Remember that economic policy really does matter!• Above all, international co-operation and

understanding are fundamental for a well-functioning world economy.