History of the World Economy

Lecture 11
The Great Depression

Pablo Martinelli
pablo.martinelli@uc3m.es
Office: 18.2.C.08
Office Hours: Tuesday, 16:00-18:00
 Introduction
• Gold-exchange standard
– Some currencies systematically undervalued while others
overvalued
– Asymmetry of the adjustment mechanism and
deflationary bias of the system
– Investors anticipated opposition to adjustment, fleeing
from “weak currencies”  Adding pressure
• Effects of WWI on world economic structure:
– Strengthened US competitive position against Europe:
trade surplus
– War debts and reparations (adding to trade deficits)
• System stability relied on US K exports to Europe
 An unstable system…
• In 1927 FED reduced interest rates to help the
struggling British Pound (by inducing inflation
in the US and making British exports more
attractive)…
• …although expansion mild and insufficient…
• …but France attracts the bulk of gold
• And a speculative bubble is set in motion in
Wall Street
• Traders buy shares at (cheap) credit…
Irrational exuberance?
 The end of US capital exports
• The stock market increasingly attractive and first signs of
recession in Germany…
• …redirected US capital to Wall Street, feeding the speculative
bubble
• In 1928, the FED raises interest rates to burst the bubble (too
successfully, in October 1929), turning the business cycle into
recession (initially, a normal one) – and attracting part of the K
that was funding Europe’s trade deficit
• Falling share prices, massive losses, asset liquidation, credit
crunch
• US capital outflows cease abruptly owing to:
– Rising interest rates in USA
– Wall Street bubble (first, profitability; after the crash, need to cover losses)
The Crash of 1929
Total U.S. Capital Outflow (1919-1933)
 The mother of all sudden stops
• Massive contraction of US foreign lending
•  Massive shock to Europe’s balance of
payments
– The new imbalance couldn’t be settled by massive
gold outflows without threatening the GS
• How to react?
• A) Abolish reparations and war debts
• B) Reduction in prices and costs (selling
European goods)
 Reparations: Young Plan (1929)
• Reparations payments reduced to 26K million $ and
rescheduled…
• …but “transfer protection clause” lifted, eliminating the
virtual seniority of repayment of private loans over
reparations payments granted by the Dawes Plan, making
it riskier lending to Germany
• Drying foreign borrowing in Germany  harder to fund
public deficits
• Initially, higher resorting on short term borrowing
• These increased doubts about the future commitment of
Germany to the Gold Standard
 Responses to capital flight?
• Expansive policies? Incompatible with the Gold
Standard
• Rising prices would have curtailed sales abroad
and domestic expansion would have increased
demand for imports
• Falling interest rates would have encouraged
further capital outflows
• Both would have increased reserve losses…
• …raising fears of currency depreciation…
• …and further capital flight
 Austerity
• An independent credit contraction had amplified the
recession in Germany already in 1928
• Capital flight added to net debtor position of Europe.
Moreover, in Germany, reparations.
• Starting spring 1929, massive capital flight
• Restrictive policies in order to contain gold losses:
rising interest rates (1929) and Brüning’s “austerity
decrees” (1930-1931).
• Result: deflation and contraction of German imports
• But continued deflation can set in motion forces
difficult to control…
 The Great Depression in the US
• Further repatriation of K from Europe, generating there further
credit crunch and recession
• Curtailment of foreign demand for US goods, deepening
financial crisis, deceleration of economic activity, fall in public
revenues
• The gov’t responded with conventional ‘gold standard policies’:
balanced budgets and monetary contraction
• Increasing protectionism: Hawley-Smoot Tariff (1930)  ↓ USA
purchases abroad (in order to redirect domestic demand
towards domestic producers)
• Sets in motion a global wave of retaliatory tariffs
• Large effects on the real economy and debt-deflation
mechanism
Number of Bank Failures (USA)
 Debt-Deflation mechanism
Share of
Real Debt + Income
-
+ Burden Devoted to
Service Debts Consumption
- -
Deflation
(↓ Prices) -
+ - - Aggregate
+ Investment
Real Interest Demand
Rates + Financial
Intermediation
Costs
+
+
+
Nonperforming + Banking Wealth Losses
Loans & +
Crisis
Bankruptcies
 Debt-deflation mechanism
• Why are falling prices harmful for a capitalist
economy?
• 1) ↑ Real burden of debt  ↑ share of income devoted to
service debt  ↓ expenditures and aggregate demand
• 2) ↑ real interest rates  ↓ investment  ↓ expenditures and
aggregate demand
• 3) If effects of 1) and 2) strong enough, further fall in prices
and ↑ in nonperforming loans  banking crisis and credit
crunch
• 4) Delayed expenditure on consumer durables
• As a consequence, aggregate demand and employment,
reinforcing the original shock
An example from Europe…
The Great Depression: transmission
• Gold standard amplified the contraction, by
avoiding national countries to reflate their
economies
• Fixed exchange rates meant that a foreign
contraction (resulting in either K flight or falling
demand) had to be transmitted to the domestic
economy
• The world fell into a contractive spiral
• But self-infliction of recessions is not compatible
with democracy in the long run…
The Great Depression: transmission (II)
• Credit crunch
• +Fall of employment and aggregate demand
• +Falling prices
• +Rising real burden of debt
• = Defaults and banking crisis
• + Adherence to gold standard = the Central
Bank cannot act as a lender of last resort
• = Banking panics and further credit crunch
World Stocks and Prices of Raw Materials

Stocks

Prices
 Solution: Reflation. How?
• Monetary expansion with fixed exchange rates
in order change expectations (from deflationary
to inflationary) and stimulate investment 
failed (required international cooperation)
• Stimulate your demand with tariffs  made, but
largely failed since everybody did the same
• Insulation from the world economy and pursuit
of independent expansionary fiscal and
monetary policies  implies abandoning the
gold standard (devaluing or with K controls)
 1931
Disintegration of the gold standard
• 1931: Banking crisis in Austria (Credit Anstalt
suspends payment)
• Default chain throughout Central-Europe
• Rising doubts about banks’ solvency
• Adding to this, doubts on the continuation of
German fulfilment policy:
– Leaked customs union with Austria
– Brüning public labelling of reparations as “tribute”
Summer 1931: German twin crises
• Simultaneous banking and currency crisis
• Main reason: Central Bank’s fundamental trade
off between acting as lender of last resort and
currency convertibility in a system of fixed
exchange rates
• Financial crisis: Bank runs - funds withdrawn
from banks threatened their solvency
• Currency crisis: Capital flight and reserve loss-
collapsing financial system raised doubts about
currency convertibility
Summer 1931: German twin crises
• Reichsbank could provide banks with the
necessary liquidity (re-establishing public’s
confidence in banks’ solvency) but that would
increase banknotes in circulation…
• …increasing pressure on reserves
• Fearing depreciation, foreign investors
accelerated the bank run and K flight
• After int’l cooperation (i.e., foreign loan) failed
and facing the exhaustion of gold reserves…
• July 1931: foreign exchange controls
 German currency controls
• Mark formally retained fixed exchange rates…
• …but currency convertibility limited – ending int’l K
mobility
• Yet Brüning continued with further orthodox
deflationary fiscal policies (further slump)
– Why not devaluing?  Foreign debt in $
– Why not inflating?  Trade surplus required to pay back
debt required int’l competitiveness + Fear of inflation (!!!)
• Willingness to achieve reparations cancellation
(eventually done, at Lausanne in 1932)
• In the meanwhile, democracy destroyed
 Fall 1931: the Sterling crisis
• British contagion: massive gold losses
• September 1931: (partly) Labour government
suspends gold convertibility
• On the free market, the Pound loses 30% of its
value until December 1931  devaluation
instead of deflation in the UK
• Without need to defend sterling’s parity,
expansive monetary policies possible
 Fall 1931:
panic crosses the Atlantic
• British experience raises doubts on the $
• Bank runs and flight from the $
• Federal reserve response: highest increase
in interest rates in history (October 1931)
• $ convertibility saved…
• …but Depression turned into THE Great
Depression
• In the USA and in Europe (except Britain)
 Gold Standard no more
• US eventually abandoned gold in 1933, with
Roosevelt’s bank holiday and suspension of
convertibility
– $ depreciation + “regime change” = inflationary
expectations
• France in gold until 1936
• The world economy disintegrates into “currency
and trade blocks” often held together by bilateral
agreements
• But this also left countries free to pursue their own
expansive fiscal and monetary policies
 Industrial production index (1929=100)

120

100

80

60
Germany

40 France
UK
20 Spain
US
0
1929 1930 1931 1932 1933 1934 1935 1936
World Industrial Production
 World
trade,
1929-1933

Note that this is in nominal

values. However, prices fell
considerably (deflation!), which
means that in real terms
(volumes traded) the collapse
might have been somewhat less
(but still very, very significant).
 Industrial unemployment, 1920–1939 (%)

50
Germany
45

40
France
35 UK
Unemployment rate (%)

30 US
25

20

15

10

0
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938
Seeds of destruction
 The Nazi economy
• Capital controls
• Foreign trade organized around bilateral clearing
agreements
• Administrative controls in order to distribute the (scarce and
rationed) imports and access to foreign exchange
• Penetrated the whole economy: price controls and quotas
• As no need to play Allies against each other and without
pressure to avoid the risk of default (after default on foreign
private loans in 1933)…
• Rearmament and deficit spending (hidden by accounting
tricks and funded by wage compression, made possible by
the administrative controls over the economy)
The disintegrated world economy
• “Sterling block” of devaluators around UK – purely monetary
recovery
• German (“Nazi”) block – K controls, public works &
rearmament program (prohibited under treaty of Versailles):
autarky, price controls and state allocation of resources in the
private sector
• “Gold block” led by France until 1936 – conventional politics
until GS was abandoned
• US isolates itself and develops a recovery policy under
president Roosevelt: The New Deal (public works, industry
coordination, social security)
• Leaving the Gold Standard is necessary to make fiscal policy
(government spending to induce economic activity) and
expansive monetary policy possible
Summary: Great Depression as a single event
• It was a macroeconomic event international in its
nature and gestation, not simply the sum of
synchronic crises
• It was characterized by worldwide falling output,
trade and prices (deflation)
• Financial and currency crises followed the decline
in real activity
• Economic policies adopted to respond to the
latter (mandated by adherence to the Gold
Standard) amplified the original slump
 Summary: Great Depression as several events
• There were “many” Great Depressions
– “Geographically”, as far as different parts of the world
economy were affected by (and reacted to) the world
economy in different ways
– “Chronologically”, since different stages of the drama
were different in nature:
• 1928-1929: the original contraction (“impulse”) in real economy
• 1929-1930: Spread (“transmission”) of the depression
• 1931: the spiral reaches vital points (banks and currencies at
the centre) - time for tough choices: accentuating the crisis or
breaking with the world economy (in absence of cooperation)
• 1932-1933 (or even later for the gold block): trough of the
crisis, disintegration of the Gold Standard and recovery
 Overall, US recovery was slow: definitive recovery
with World War II
1933
Roosevelt assumes 1942
office: Start of New Complete
Deal recovery
after Pearl
Harbour

1937-38
Second
New Deal
(NLRA, etc.)