Y3869464 Bubbles, Panics and Crashes Examination ECO00018H

Answer B: What was the legacy of World War I for the Great Depression?

The Great Depression is the period of longest and most severe worldwide economic
downturn, which started in 1929, leading to massive losses in output, steep decline in prices,
mass unemployment, banking crisis and sharp rise in the level of poverty in major
economies, such as the USA (B. Duignan, Brittanica). ​Its severity was precisely due to the
fact that so many economies were affected by the crisis (Pells and Romer, 2020).

In the post World War 1 (WW1) era, the US economy mostly experienced an overall healthy
and stable economic conditions (Parker, 1999): almost stable GNI during most of the 1920s
and only minor falls of 1% to 2%, due to a limited “post-war” recession. While there is much
speculation about the drivers of this catastrophic crisis, economists seldom blame the legacy
of WW1, as both the US and Europe had seemingly recovered from the war and
experienced high rates of growth. This essay aims to argue that to a large extent, the drivers
leading to the Great Depression were the structure and the operation of the interwar gold
standard, debt deflation and poorly managed monetary and fiscal policies, but also
discusses substantial effects of WW1.

Firstly, we will take a look at the impact of the interwar Gold Standard. By 1928, major
economies such as the US, Britain, France and Germany had re-established the Gold
Standard, after it was previously suspended during the war. However, Eichengreen (1985)
argues that the post-war Gold standard was different to that before the war. Most major
countries were unable to maintain strong fiscal policies and monetary policies that would be
consistent with the long-term price stability and continuous convertibility of the currency,
which were key criteria for its successful operation. Hamilton (1988) argues that the Gold
Standard was used more as a support mechanism to the political chaos following the war.
Moreover, pre-WW1 success of the Gold Standard was credited to the able leadership of the
United Kingdom (Kindlberger, 1986), which was no longer the case in the post-WW1 era
when the United States of America (USA) took the lead. Following the imposition of high
tariffs in the USA, and slow recovery of most european economies, the USA tended to run a
trade surplus with other countries. ​Such imbalances gave rise to significant foreign gold
outflows to the USA, which in turn threatened to devalue the currencies of the countries
whose gold reserves had been depleted. Accordingly, foreign ​central banks​ then attempted
to counteract the trade imbalance in their Balance of Payments by raising interest rates,
which lead to reduced price level and real output, and increased unemployment in their
countries. The result was a steep economic decline in Europe which was comparable to the
USA.

Evidently, countries that left the Gold Standard earlier had recovered from the Depression
quickly (Eichengreen and Sachs, 1985), as departure from the gold standard meant less
deflationary pressure. For example, Spain, which never returned to the gold standard,
skipped the Depression altogether. Economists also argue the interwar gold standard was
flawed, such as it lacked symmetry towards gold-gaining and gold-losing countries. This
caused significant deflationary bias, and further expanded the depression and deflation that
the countries were experiencing, causing severe impacts of the Great Depression.
Y3869464 Bubbles, Panics and Crashes Examination ECO00018H

Fisher’s debt deflation theory, in contrast, argues that the leading cause of the Great
Depression was large volume of debt combined with deflation. According to Fisher (1933),
there is bound to be debt liquidation if over-indebtedness is present, which leads to a
decrease in the velocity of money, i.e monetary contraction. Following this, the price level
may drop, and substantially increase real debt burden. Falling price levels will lower the AD,
and cause falling profits for businesses - therefore leading to lower wages and downsizing of
labour, which in turn increases unemployment, and slowing of the “velocity of money”.
Businesses may also go bankrupt if they are unable to return the increased real debt.
Deflation can be disastrous for any economy, according to Fisher, when it is paired with
debt.

Alternatively, the outbreak of the Great Depression can be viewed as a result of improper
monetary and fiscal policies. Friedman and Schwartz (1963) view the Great Depression as a
failure of the Federal Reserve (FED). The FED reduced money supply to counter falling
money demand in 1929 and unemployment. Instead, Friedman and Schwartz believe, an
increased money supply was necessary to offset the dire economic conditions. As the
‘lender of last resort’ the FED arguably should have stimulated the economy, however, this
was a responsibility they failed to enact. Keynes also argued that governments failed as they
were busy balancing their budget, and acted like private investors; instead of reducing
spending, they should have increased it to mitigate any severe impacts on the economy, as
increasing government spending would create jobs and provide the much needed economic
stimulation. In a crisis, the government should invest, as it is the only agent left which can do
so, and when the crisis is over, taxes should be raised to pay back the debt.

Constructively, H. Hoover (1952) mentions in his memoirs that WW1 was to blame for the
Great Depression, and some economists agree with his claim. M. Klein (2001) mentioned
that the aftermath of WW1 was slowly leading up to the Great Depression. While economic
conditions in the USA were stable in the 1920s, the unequal distribution of wealth was
increasing, as well as a lack of government regulation of banks, which allowed for bad
practices and eventual stock market crash and banking panics. European countries were
faced with high war debts, and the high tariff introduced by the USA in 1922 further led to
stagnation of international trade. The USA undoubtedly came out of the war as the leading
economic power, but their retreat from international trade may have hindered international
economic recovery. While WW1 ended, it left countries taking an inward turn with
protectionist policies and lower cooperation, eventually leading to recession in most
countries just before 1929.

In conclusion, while World War 1 did have substantial effects that impacted countries with
poor reserves and slow economic recovery, the inappropriate economic conditions for the
re-establishment of the gold standard, debt deflation, and poorly executed monetary and
fiscal policies resulted in the failure of the major economies and to the spread of the
depression across the world. This is because the Great Depression spread out and impacted
almost all the countries with severe economic downturn, not only major nations.
Y3869464 Bubbles, Panics and Crashes Examination ECO00018H

Bibliography:

1. Eichengreen, B. & Sachs, J. (1985). ‘Exchange Rates and Economic Recovery in the
1930s’, ​Journal of Economic History,​ Vol. 45, No. 4, pp. 925-46.
2. Fisher, I. (1933). ‘The Debt–Deflation Theory of Great Depressions’, ​Econometrica,
Vol. 1, No. 4, pp. 337-57.
3. Friedman, M. & Schwartz, A. (1963). ‘A Monetary History of the United States,
1867–1960’, ​Princeton, NJ: Princeton University Press​.
4. Hamilton, J. (1988). ‘Role of the International Gold Standard in Propagating the
Great Depression’, ​Contemporary Policy Issues,​ Vol.​ 6, No. 2, pp. 67-89.
5. ​Kindleberger, C. (1986). ‘​The World in Depression​, ​1929–1939’​, ​Berkeley: University
of California Press​.
6. Irwin, D. (2010). ‘Did France cause the Great Depression?’, ​National Bireau of
Economic Research.​
7. Kindleberger, C. (1986). ‘​The World in Depression​, 1​ 929–1939’​, ​Berkeley: University
of California Press​.
8. Kindelburger, C. & Robert, A. (1978). ‘Manias, Panics, and Crashes’, ​John Wiley &
Sons, Inc., Hoboken, New Jersey.
9. Parker, R. (1999). ‘The Twentieth Century: A Theological Overview’,​ Orbis Books
Maryknoll, N.Y,​ p. 263.
Y3869464 Bubbles, Panics and Crashes Examination ECO00018H

Answer F: Was the Greek financial crisis of 2009 to 2015 a government debt crisis, a
banking crisis, or a currency crisis?

The Greek financial crisis came into public attention in 2009 after the newly elected Greek
government announced that Greece’s budget deficit will exceed by more than 12%, more
than doubling previous expectations, and a possible sovereign bond default. As a part of the
Eurozone, they largely exceeded the terms agreed under the European Union Stability and
Growth Pact.

So when can a period of financial crisis be defined as either a banking crisis, government
debt crisis or currency crisis? A banking crisis occurs when there is a sudden rush in
withdrawal among the depositors in the country due to loss of confidence in banks;
government debt crisis occurs when the government fails to return its debt and the
government bond defaults; and currency crisis, also known as devaluation crisis, occurs
when the currency declines in value extensively.

The Greek financial crisis is defined as a government debt crisis because it arose due to the
large debt burden that the “insolvent” government could no longer meet.

The prime reason for the occurrence of this crisis is because Greek government had been
experiencing fiscal deficits since the late 1980s, building up a large debt burden, as they
carried out lavish government expenditure to ensure political support and stimulate
economic growth. However, the policies chosen were undoubtedly unsustainable; for
example, s​alaries for workers in the public sector rose automatically every year, instead of
being based on factors like performance and productivity.

Between the 1990s and 2000s, foreign banks lent large volumes of debt to Greek
government to finance their unsustainable fiscal spending. ​While high fiscal spending fuelled
economic growth, it did not have a similar positive impact on unemployment. Greece’s
impending membership to the Eurozone also encouraged investors to buy sovereign debts
and drive down interest rates - which further aided to improve living standards by increasing
exports into the country. While overall Greek economic conditions were prosperous,
investors failed to notice the warning signs: unsustainable debt levels, excessive public
spending and high wage growth not supported by growing productivity. In the wake of the
Global Financial crisis, Greek government further undertook higher debts as they had to
cope with a fall in revenues and rise in spending, whilst foreign banks chose sovereign
bonds as safer heaven.

However, by 2010, lenders finally lost confidence in the ability of the Greek government to
pay its debts. The government admitted that it could no longer make debt payments; faced
with a sovereign bond default then, they took bailout loans from the International Monetary
Fund (IMF) and European Union (EU). Although these bailouts were used to pay-off some
older loans, the overall debt burden was still increasing. By early 2013, the EU and IMF
loans added up to about 65% of the Greek government’s foreign-owed debt. The EU and
IMF insisted on a widespread “draconian” austerity programme in Greece to lower the debt
levels. The austerity programme, added with no control of monetary policy due to Eurozone
Y3869464 Bubbles, Panics and Crashes Examination ECO00018H

rules, eventually led to high unemployment, plummeting incomes and widespread poverty in
the country, deepening the crisis further.

Since the 1990s, banks from countries such as Germany and the UK lent to the Greek
government to finance their lavish expenditure, but failed to do the correct due diligence in
terms of the government’s solvency to repay the debt. This led to misconception among
private investors who continued to buy Greek sovereign debt, following market trends. In the
wake of the Great Financial crisis of 2007, banks were more inclined towards sovereign debt
as safer havens, and therefore increased lending to Greek government, until they finally
grew cautious in 2010 about a possible government default. Therefore, it can be argued that
the banks played a role in forming a private sector credit bubble for Greek sovereign bonds.

Since international banks from Germany and France also carried out inter-lending between
countries, such as lending to governments of Portugal, they were responsible for initiating
the Eurozone crisis, where the Greek economic problems were slowly passed on to
countries such as Portugal and Ireland as banks restructured their portfolio to shared
macroeconomic risk in the Eurozone. However, throughout the crisis there were no major
possibilities of bank defaults in Greece as investors were confident most European countries
or the EU would bail out Greece, as the debt was mainly owned by banks in Germany and
France, and a Greek Default would mean international investors would suffer the losses
destroying economic stability in their countries. ​Greece was eventually bailed out by the EU
and IMF, so there were no bank runs or panics during the period. This rules out a banking
crisis.

A. Kindreich (2017) mentions that “many of the woes of ​Greece’s financial crisis stemmed
from its membership in the Eurozone.” It is often argued that although Greece joined the
Eurozone in 2001 to enjoy the benefits of the adoption of Euro, they were far too early for
their case; for example, their budget deficit and debt levels were much higher compared to
the levels agreed under the terms of EU Stability and Growth Pact. While adoption of the
Euro had its benefits, such as a stable price level, it surely did have detrimental effects on
Greece’s policy making. For example, when Greece was faced with rising interest rates in
the aftermath of the Government Debt crisis, they could have devalued their currency to take
the pressure off interest rates. However, in the Eurozone, ECB decided on the interest rate
to ensure stability across the Eurozone, not for a single country, and therefore Greece had
lost control over their monetary policy. At the height of the crisis in 2010, Greek bond yields
soared as investors wanted higher reward for holding the risky debt, and this eventually led
to severe contraction in their GDP and falling living standards. Therefore, it can be
successfully argued that the crisis was not a currency crisis as there was no massive
devaluation of the Euro.

Finally, it can be concluded that the Greek Financial crisis was a government debt crisis, as
the Greek government would default on their bonds, if they had not been successfully bailed
out by the EU and IMF. Furthermore, Greece did not experience any bank runs or panics in
the build up or the aftermath of Greek Crisis, neither did the Euro devalue extensively as it
was managed by the ECB. It was a problem at the core of the Government's solvency and
there, a sovereign debt crisis. Greece still continues to heavily rely on government spending
as a part of GDP, almost about 50%, while also relying on EU bailouts.
Y3869464 Bubbles, Panics and Crashes Examination ECO00018H

Bibliography:

1. The Greek Financial Crisis 2009 - 2016, Adam Kindreich (2017)

2. (​https://www.thebalance.com/what-is-the-greece-debt-crisis-3305525​)

The Greek Debt Crisis Explained

3. The Greek Debt Crisis: A case of Banks before People

(​https://jubileedebt.org.uk/countries-in-crisis/greek-debt-crisis-case-banks-people​)

4. Greece’s Debt Timeline (Council on Foreing Relations)

(https://www.cfr.org/timeline/greeces-debt-crisis-timeline)

5. Explaining Greece’s Debt Crisis

(https://www.nytimes.com/interactive/2016/business/international/greece-debt-crisis-
euro.html)