Liaquat Ahamed
How Policymakers Can Avoid the Perils of the 1930s
In
The global economy was still mired in a depression that had begun more than three years earlier. In the two countries hardest hit,
The purpose of the conference, originally conceived in the last days of U.S. President Herbert Hoover's administration, was to spur a joint effort to repair the severely damaged international financial system. But the new U.S. president,
It appeared as if policies in the two biggest economies in the world,
In an ominous hint of his attitude toward the conference, Roosevelt stayed home -- choosing instead to vacation in
At the last moment, just as an agreement on stabilizing exchange rates seemed imminent, Roosevelt's attitude hardened. He became concerned that economic recovery at home would be stymied if the
Although Roosevelt was maligned at the time, his decision to devalue the dollar in 1933, by allowing
FROM LONDON TO SEOUL
After the 2010 G-20 meeting in
Ever since the latest global economic crisis began in the fall of 2007, commentators have been drawing parallels between current events and those surrounding the Great Depression. In both cases, there was a preceding decade of easy credit, overborrowing, and excessive leverage, which eventually led to an asset bubble. Then, it was in the stock market; this time, real estate. In both cases, the bursting bubble and the ensuing economic downturn led to a series of banking and sovereign-debt crises.
At the root of many of the problems of the interwar years was a malfunctioning global financial system. Policymakers then had to contend with misaligned exchange rates, apparently intractable current account imbalances, and the growing threat of protectionism. As the Seoul G-20 meeting so vividly illustrated, their counterparts of today are struggling with very similar challenges.
The experience of the interwar years is therefore rich with lessons for today's policymakers and can shed light on a number of crucial questions facing world leaders in 2011. Why have global imbalances been so intractable? What should be done about them, and in light of what happened in 1929, what should not be done? Is all the talk of currency wars overblown, or does it accurately reflect the increased risk of competitive devaluations? And does the recent escalation in tensions over exchange rates and monetary policy foreshadow a spiral of the sort of beggar-thy-neighbor policies that came out of the Great Depression?
A CROSS OF GOLD
World War I caused a seismic shift in capital flows and trade patterns around the world. The major European nations, having spent some 50 percent of their GDPs on the war effort for four full years, were left saddled with gigantic debts and were able to recover only by borrowing from
Prior to the war, under the classical gold standard, countries were supposed to operate according to certain "rules of the game" in dealing with trade imbalances. Because domestic money supplies were rigidly linked to gold reserves, those countries accumulating reserves would automatically experience easy credit, strong demand, and rising prices. Meanwhile, countries with diminishing reserves faced the converse: tight credit and falling prices. So even though currency rates were fixed against one another, trade imbalances were largely self-correcting, without the need for protracted negotiations between countries.
There was always an inherent asymmetry about the whole mechanism. Deficit countries had no choice -- they had to contract credit; otherwise, they would run out of gold. By contrast, the pressure on surplus countries to expand credit was not as strong. Nevertheless, during the nineteenth century, because trade imbalances were small and temporary, the integrity of the system survived.
In the 1920s, the shifts and fluctuations in gold reserves were simply too great, and the system came under considerable strain. The problems created by this skewed distribution of reserves were compounded by the way European countries, which had broken the link with gold when war was declared, returned to the fixed exchange rates of the gold standard. The
With all their gold, both
The full burden fell on the deficit countries. During the 1920s,
After the onset of the Depression in 1929, as international financial markets progressively seized up, bankers stopped lending to
In 1931, as fears about the stability of the pound spread, central banks around the world started dumping pounds in favor of gold. In the ensuing scramble for gold, central banks tightened credit by raising interest rates, even though unemployment was well into double digits. More than anything else, these moves turned what was already a severe depression into the Great Depression.
The example of the
The process was made even more protracted and difficult because
THE DOLLAR DILEMMA
The international financial system today is very different and much more flexible. Most major currencies -- the dollar, the euro, the pound, and the yen -- as well as a host of other minor currencies, such as the Swiss franc, the Australian dollar, and the Canadian dollar, float against one another.
There are two exceptions. The economies within the eurozone have given up their national currencies. As a result, countries such as
The other major exception is the so-called dollar bloc. In the wake of the 1997-98 Asian financial crisis, some of the affected countries sought to build up dollar reserves as insurance against future domestic bank runs or downturns in the global economy. At about the same time,
Like
Because of the dollar's status as the world's primary reserve asset, such trade imbalances are not as dangerous a source of instability as they were in the 1930s. Unlike
Even though two of the levers for curing the trade imbalance between
When the recession first hit, it seemed that this mechanism was kicking in. U.S. consumers, drowning in debt, tightened their belts and sharply raised their savings rates. Chinese exports were particularly hard hit by the downturn. For a while, it looked as if
Going forward, if
REEVALUATING DEVALUATION
The lesson of the 1920s is that rigidly fixed exchange rates are dangerous. Conventional wisdom holds that the lesson of the 1930s is the converse -- that the fixed exchange rates of the gold standard were replaced by a disorderly system of floating exchange rates that led to competitive devaluations, which were in turn the catalyst for a disastrous move to protectionism. This narrative only captures part of the story.
It is true that during the 1930s, one country after another, faced with mass unemployment and excess capacity at home, adopted a deliberate policy of driving down its currency in an effort to make its goods more competitive so as to export its way out of depression. The spiral began in the fall of 1931, when the pound was forced off the gold standard, and gained its full momentum after the dollar devaluation of 1933. With everyone trying to devalue, no single country was able to gain a competitive advantage for very long, and the whole process became self-defeating. The devaluations occurred in such an uncoordinated and disruptive sequence that states lost confidence in the open global economy's ability to reconcile their conflicting interests and ambitions. Turmoil in the exchange markets continued until the end of 1936, when
Despite the chaos of floating exchange rates, the disruptions and costs produced by competitive devaluations have been greatly exaggerated. The dollar devaluation of 1933 did give U.S. goods a competitive edge in world markets and helped
With the industrial world having largely moved to floating currencies, exchange rates are no longer a policy instrument under the direct control of governments. There are, however, some superficial resemblances between the intended effects of the "quantitative easing" undertaken in 2010 and those of the dollar's fall in 1933. Both were designed to raise inflationary expectations, boost asset prices, and revive spending behavior. In addition, since any sort of monetary easing, quantitative or otherwise, generally increases the likelihood of a declining dollar, both policies potentially improved the competitiveness of
NONE OF US WERE KEYNESIANS THEN
For all the parallels, there are numerous reasons why the global economy is unlikely to see a spiral of competitive devaluations similar to that of the 1930s. First, the U.S. external position is now very different. When the dollar was devalued in 1933,
To understand the reaction in the 1930s to the decline of the dollar, imagine the international response if
Second, policymakers now have access to a greater number of tools to promote recovery. Even after the major economies had abandoned the gold standard in the 1930s, most officials still continued to espouse the doctrine that budget deficits were always a bad thing. John Maynard Keynes' General Theory of Employment, Interest, and Money, which first articulated the benefits of temporary deficit spending, was not published until 1936, and it took many years for his ideas to be accepted. At the time, almost no country --
Third, unlike in the 1930s, the whole world is not mired in depression. Primarily because of the deft use of fiscal policy in 2008 and 2009, the emerging markets, particularly
Even if there is no wave of competitive devaluations, will the current tensions over currencies and trade imbalances lead to more restrictions on trade? So far, increases in protection have been relatively minor. In part, that is because the structure and networks of world trade are so different today. Thanks to global supply chains, countries are far more integrated. Companies that produce for the domestic market and would normally be strong advocates of import restrictions are themselves dependent on imported inputs. Moreover, all the various General Agreement on Tariffs and
Recent research by the economists
A LEADERLESS ECONOMY
The economic historian
Before World War I, the global economy operated smoothly only because it was in the interest of the
After 1945,
Today, the global economy has arrived at a similar inflection point.
If no single country is in a position to be responsible for stabilizing the global economy when it suffers a shock, is there an alternative mechanism? The hope is that because of the G-20, nations can be goaded by their peers to act in concert to sustain demand and keep markets open without the sort of backsliding and freeloading that Kindleberger feared would occur. One year into the crisis, at the G-20 meeting in
The world managed to avoid a repeat of the Great Depression this time because, in contrast to 80 years ago, countries pursued the right macroeconomic policies -- protecting and recapitalizing their banking systems, cutting interest rates to the bone, and letting their budget deficits expand enough to absorb some of the slack in the economy. They were able to do all these things in part because they faced a much more flexible international financial system. In the 1920s, countries were constrained by the imperatives of the gold standard, which straitjacketed economic policies. But in part, countries today pursued the correct policies because they had the example of the Great Depression available to them as a case study of what not to do.
As the recovery has begun to take root, similarities between the period after 1933 and today have begun to surface. Despite the rebound, unemployment remains high, many sectors of manufacturing are suffering from excess capacity, and currency tensions are on the rise. Having so successfully averted the mistakes that made the slump of the 1930s so deep, it would be truly tragic if policymakers were now to repeat the beggar-thy-neighbor policies that made the 1930s a time of the worst sort of populism and nationalism.
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