Lessons from the Great Depression

by Philipp Requat (Op Ed, European Ideas, 19.06.2013)

In the midst of the continental muddle that has come to be known as the “Euro crisis”, curious macroeconomic advice and judgement have become all the rage on the forums of the World Wide Web. When recently dabbling through the economic corner of an Austrian daily’s online presence, I came across a claim that struck me both for its positive resonance as well as its intellectual audacity.  The heartily approved post can be summed up as follows:

It has been proven beyond doubt by the economic profession that inflation or inflationary measures have only ever been harmful for economic development.

Drawing on the work of various economic luminaries across political boundaries, I will attempt to refute this statement. Specifically, the Great Depression will be shown as one significant case in which the very opposite was true.  The severity and duration of the 1930s global economic contraction was largely hinged on governmental failure to abandon deflationary policy in favour of reflation.

Some scholars have traced fears of inflation back to the Weimar republic’s early 1920s hyperinflationary bout. (Ferguson, Roubini 2012) Economically crippled by the weight of exorbitant WWI reparations payments, German Central bankers temporarily sought to print their country out of crisis/illiquidity. The outcome of their excessive monetary expansion in a climate of grave domestic economic insecurities was a destructive spiral of rising prices. Yet, as dramatic as the years of galloping inflation might have been for savers, their suffering was dwarfed by the events surrounding the deflationary escalation of what had been a mild recession until 1929.

 Ten years earlier, in the wake of the fateful peace of 1919, the world’s international financial architecture had come to rest on rickety foundations. In the ashes of the first total war, even the victorious European powers were left with straddling debt, most of which was owed to a nascent American hegemon. To service these obligations, capital gained from reparations levied on Germany and the successor states of the Austrian empire was channelled to New York. The impoverished defeated nations themselves relied on sovereign borrowing of mainly U.S. capital to enable the short-lived functioning of the resulting cycle of capital flows.(Keynes 1920) It was after World War I that the United states finally completed its transformation from a debtor to a creditor nation, taking Britain’s place as the primary exporter of capital.(Temin 2008, Eichengreen 2008) Defying a number of post-war speculative financial booms and impressive American and French growth throughout most of the early 1920s, increasing instability gradually crept into the global economy. As most countries returned to the gold standard near or at pre-war parities, exchange rates no longer befitted the international structure of finance and failed to reflect substantial capital destruction during the war. Fatally, the backing of currency with gold restricted manoeuvring space for domestic economic policy. As Temin concisely put it, the standard “mandated deflation rather than devaluation as a remedy for foreign exchange deficits, and placed far more pressure on debtor deficit countries to contract than on surplus countries to expand”(Temin 2008).

Even Britain found itself in considerable difficulty due to Churchill’s return to “normalcy”, as exports lost their international competitiveness under the pound’s exaggerated evaluation. The burden was higher still in central Europe, exacerbated early on by investors’ speculations that vanquished countries like Germany and Austria would not be able to hang on to gold. For years after the war, France and the United States, which were most dedicated to the standard, made huge economic gains because of their safe-haven status. (Temin 2008, Eichengreen 2008) In a staggering example of short-sighed economic nationalism, they engaged in deflationary sterilisation or hoarding of gold, refusing to reinvest significant amounts of capital fleeing other countries. (Sidelsky 2009) Consequently, the likelihood of economic recovery in Central Europe and by extension the ability of its governments to service their debt narrowed. Echoing contemporary debates on the treatment of Southern European debtors, the U.S. and France had failed to recognise that they too would eventually feel the repercussions of an international credit crunch.

In the first of a series of key events that culminated in the Great Depression, the U.S. Federal reserve began to contract monetary supply in 1928, in an attempt to halt what it considered a speculative stock-market boom. Although they have been popularized as significant causes for America’s economic contraction, the stock market crash of 1929 and Smoot Hawley Tariff Act of 1930 that tailed the Fed’s intervention can only be seen as exacerbating factors. More so than the10% reduction in private wealth caused by the former, and the wave of retaliatory tariffs and decline in international trade caused by the latter, the crisis of banking that marked the early 1930s stands deserves attention.(Friedman, Schwartz 1963) The 1930 collapse of the Bank of United States is a commonly cited example. In this early stage of the crisis, interest rates remained low as the depression operated through credit-rationing. (Bernanke 1983) Especially small firms suffered from prohibitively expensive credit lines as banks became reluctant to extend new loans. The wary institution’s attempts to lower their risk in an unstable banking environment were accompanied by a strong general decline in industrial output. All but the largest entrepreneurs were being starved of credit, yet the giants too could not escape the duress of slowing consumption. (Bernanke 1983)

 Adding to the gloom, a collapse and ensuing depression of agricultural and raw material prices followed the end of WWI hostilities. When European production picked up again, farmers throughout the world were left with massive overcapacities. The downward trend accentuated dramatically after the 1929 stock market crash. As a consequence widespread defaults by agricultural producers undermined faith in financial institutions. Most industrial nations initially achieved aggregate gains due to the relatively small size of their agricultural sectors, but growing credit stringency quickly saw a deflationary epidemic of falling prices spread across entire economies. (Bernanke 1983, Temin 2008, Eichengreen 2008)

It was around 1931, when the economy failed to recover quickly as it had in previous instances, that the Mundell effect became apparent. Working through deflationary expectations of lower prices, investment and consumption were curtailed. A severe depression was thus transformed into a Great one, a process to which the Federal Reserve would make a tragic contribution. Underlining the international dimension of crisis, the deterioration of economic fortunes was felt in the shape of a European currency crisis shortly thereafter. The first domino stone to fall was Creditanstalt, Austria’s largest bank. The Viennese arm of the waning Rothschild empire was wrought to bankruptcy by its failing involvement in Hungary and sparked a run on the Schilling, as it had to be rescued by the state. Panic spread to Germany, with a run on the Deutschmark forcing policymakers to restrict the sale of gold. By imposing capital controls to preserve their central bank’s reserves, both Germany and Austria were effectively forced off the Gold Standard. Britain followed suit, continuing to sell gold albeit no longer at fixed prices. (Bernanke 1983, Temin 2008, Eichengreen 2008, Friedman, Schwartz 1963)

Investors figured the U.S would be next. The Fed chose to resist expectations of a dollar-devaluation by hiking interest rates, thereby speeding up the contraction of money supply. As an exception to the rule, the Hoover administration oversaw a short period of expansionary monetary policy in 1932. Efforts were not serious enough to turn the deflationary tide and the policy was abruptly ended as France and Britain began to withdraw their dollar balances out of fear of devaluation. Overall, Hoover’s government and the Federal Reserve maintained a concerted and consistent, if misguided, act to preserve the value of the dollar within the Gold Standard. (Temin 2008, Eichengreen 2008, Bernanke 1983, Sidelsky 2009 ) The fruits of this stance were an unprecedented free-fall in industrial output and the deepening of the depression. Although a vicious cycle of low investment, low demand and low employment was entered, exits were available. Producers and consumers in major industrial nations simply reacted to a deflationary government position and associated economic expectations. A strong symbol of policy change proved enough to commence on the long path of recovery.

President Roosevelt, who succeeded Hoover in 1933, campaigned on inflationary promises of devaluing the dollar. In the infancy of his term, he declared the national March bank holiday. Rather than being a strategic move, Roosevelt was forced to declare to holiday to prevent a banking meltdown. Calls for leaving the gold standard during the campaign had spooked investors to sell dollars and seen the New Yorker Fed run dangerously low on its gold reserves. As impotent as Roosevelt was in the circumstances of the bank holiday, he keenly imposed controls during it that allowed the circumvention of speculative disequilibrium when the devaluation of the dollar began. (Temin 2008)

Eichengreen has noted that devaluation need not be a “beggar thy neighbour policy” if the newly gained space for macroeconomic manoeuvre is used for expansion, especially if all countries do so.(Eichengreen 2008) By 1933 virtually all nations had departed the gold standard with exception of die-hard members such as France. The French paid for their adherence to the standard until 1936, by experiencing the longest depression amongst all affected countries. From his inauguration onwards, Roosevelt began to replace Hoover’s passive deflation with aggressive interventionist expansionary policy. Despite its inconsistencies, the New Deal had a steady expansionary bias for which it was lauded by personalities such as Keynes and J.P. Morgan. Contrary to the fears of National Chase Bank’s Winthrop Aldrich, who predicted an “act of economic destruction of fearful magnitude”, the stock market nearly doubled in the 2nd quarter of 1933.  Falls in the value of the dollar were met with sharp rises in commodity prices. (Temin 2008; Keynes 1933; Friedman, Schwartz 1963; Bernanke 1983)

Recovery was not instantaneous and unemployment remained high until the 1940s. Nevertheless, signs are evident that recovery began after the bank holiday. Most Western economies experienced rapid economic growth from 1933 to 1937. Fiscal policy was largely irrelevant in this development. The U.S. and nearly all other major industrial nations, including those with low levels of sovereign debt, refused to run the deficits that a Keynesian expansion would have mandated. While the FED remained passive, monetary expansion was achieved, with connected inflationary conditions and expectations taking hold. Economists such as Bernanke, Temin, Friedman, Schwartz and Eichengreen have emphasised the crucial nature of this development for recovery. Furthermore, gold that began to flow into the U.S. again was not sterilized anymore, marking a departure from previous habits.  (Bernanke 1983; Temin 2008; Friedman, Schwartz 1963; Eichengreen 2008)

Inflation is no panacea that should be employed or encouraged without bounds. Whether or not it can bring more relief than distress to an economy depends on macroeconomic circumstance. 1970s inflation might have been bad news for banks with fixed mortgage arrangements, but it also made it easier for young people to acquire property. The contemporary picture is very far removed from the risk of hyperinflation. Inflation rates in the Euro-zone have been falling since 2009, down to an annual rate of 1.4% recorded this May. Historically this figure is well below the annual average of 2.26% between 1991 and 2013.(Eurostat) Compiled with the macroeconomic policy constraints of a currency union that are akin to those of the Gold Standard, deflation seems a more tangible risk than inflation today. A bit of the latter, which would also encourage current account- and budget surplus countries to reinvest their gains, might just smoothen the Eurozone’s woeful and protracted deleveraging phase.

Citations and References

B. Bernanke, Non-Monetary effects of the financial crisis in the propagation of the Great Depression (1983) American Economic Review, vol. 73, no.3 pp. 257-276

B. Eichengreen, Globalizing Capital: A history of the international monetary system (2008) Princeton: Princeton University Press

N. Ferguson, N. Roubini, “Berlin is ignoring the lessons of the 1930s” article in Financial Times (08.06.2012) London

M. Friedman, A.J Schwartz „A Monetary History of the United States 1867-1960 (1963) Princeton: Princeton University Press

M. Hammersely, “Standards for assessing ethnographic research” in Reading ethnographic research: a critical guide (1998) pp.58-77 London: Longman

J.M. Keynes, The Economic Consequences of the Peace (1920) New York: Harcourt, Brace and Howe

J.M. Keynes, “An open letter to President Roosevelt” article in The New York Times(31.12.1933)

R. Sidelsky, Keynes: The return of the master (2009) London: Allen Lane

P. Temin, “The Great Depression” in The Cambridge Economic History of the United States (2008) S.L. Engerman, R. E. Gallman(eds.) vol. 3 Cambridge: Cambridge University Press

Original Article