Lessons for now from the 1920s and 1930s

Lessons for now from the 1920s and 1930s David Vines, University of Oxford, Australian National University and CEPR

Introduction • The importance of growth • The nature of the global system pre World War I • Keynes on impediments to growth • Need for adequate aggregate demand • Need for internal and external Balance • Using this framework to understand the 20s and 30s • Debt • Adjustment • Overall demand • Using this framework to understand the present European crisis • Debt • Adjustment • Overall demand • This is a story about the use of theory as well as about a comparison facts. It largely follows Temin and Vines (2013) The leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press)

1 Insights from John Maynard Keynes 1.1 The Economic Consequences of the Peace (1919) Keynes thought that Europe had worked the following way • Rapid labour-saving technical progress and rapid labour force growth • High savings rate • This was an international system within Europe • Moreover it was a global system: Ideas relate to the Ramsey model (1928) the Lewis Model of the 1950s This is a real story about economic growth. The Economic Consequences identifies one way – a debt burden caused by reparations – which might make this system break down.

Nevertheless the ‘psychology of society’ was such that there ‘grew • around the non-consumption of the cake … instincts of puritanism…And so the cake increased [ by means of capital accumulation]; but • to what end was not contemplated… Individuals [were inclined] not so much to abstain as to defer’.

‘…the increasing pace of Germany gave her neighbours an outlet for their products, in exchange for which the enterprise of the German merchant supplied them with their chief requirements at a low price’

‘[t]he accumulative habits of Europe before the war were the necessary condition [for this growth]: …[o]f the surplus capital goods accumulated by Europe a substantial part was exported abroad, where its investment made possible the development of the new resources of food materials and transport, and enabled the Old World to stake out a claim on in the natural wealth and virgin potentialities of the New’

1.2 The Macmillan Committee (1930) • It is possible to see Keynes at work at the Macmillan Committee in 1930, just ten years after he had written the Economic Consequences. What one sees is someone who has not yet provided the analytical tools with which to understand this breakdown • The Macmillan Committee was a high level Committee convened by the new Labour Government in 1929 • Before the sterling crisis of 1931, but five years after the British return to the gold standard • Provided Keynes with 8 full days to expound his views • “[T]hey found my speech perplexing. I think that I did it alright. But it was unfamiliar and paradoxical” • The committee were right to find it perplexing.

1.3 Aggregate Demand, Internal Balance and the path to the General Theory • First, what happens if the ‘psychology of society’ is such that investors are not prepared to make use of the available savings (c.f. the argument of the Economic Consequences). Keynes analyses this problem in the light of Britain’s unsuccessful return to the gold standard. He describes how the tight monetary policy which that required led to a situation in which investment falls relative to saving. • He describes how this causes unemployment. This is in turn meant to cause wages to fall, and so bring about an adjustment of competitiveness, but • he thinks that the required wage adjustment is too large • he does not have the tools necessary to say how much unemployment will emerge – since his model, explained at length, assumes full employment! • To do this he set out to write his General Theory. • This shows how the process of real growth, on which he had focused in the Economic Consequences can be impeded by inappropriate monetary policy – and how - when this happens, fiscal intervention can produce a better outcome. This had not been understood in 1919 and it was not understood by Keynes in 1930.

1.4 Internal Balance, External Balance and the Bretton Woods System • At the Macmillan Committee Keynes showed how the gold standard leads to adjustment difficulties. • Wage cuts too slow • But he did not advocate abandonment of the Gold Standard • His positive proposals are for demand expansion which would make the external position worse • He advocates protection as a way of dealing with the external position • There is a discussion of why devaluation is better than protection but he does not advocate it • In his initial Clearing Union proposals of 1941 he still does not find a solution • The clearing union proposals involve the creation of international liquidity, enabling a country in deficit to run an ‘overdraft’ • But this does not tackle the process of adjustment. • If wage and price adjustment is too slow and if protection is to be ruled out then how is international adjustment to take place? • It takes until the run-up to Bretton Woods in 1944 to reach a worked out adjustment mechanism.

The point reached is that explained by Meade (1951) and in the Swan diagram (1956). • to achieve both internal and external balance two instruments are needed – domestic demand management (either fiscal and monetary) and (real) exchange rate change • A country in external difficulty needs to be able to avoid constraining domestic demand to reduce activity and reduce demand for imports only by means of austerity. • It can do this by devaluing the currency, and by judging the degree of austerity by the amount necessary to release the resources which are demanded for net exports as a result of the currency depreciation • This adjustment will take time and the country needs to be able to borrow during the adjustment period – officially and from the market • IMF practice came to involve lending, with conditionality, to ensure markets that the adjustment will actually take place

1.5 Understanding the Nature of Keynes’ contribution Between 1919 and 1944, Keynes is describing a combination of private sector impediments, and inadequate policy responses, which can stand in the way of the long run growth picture which he had identified in the Economic Consequences In what follows we sue this framework to describe the impediments to growth problems of the 1920s and 1930s and those of the present

2 The Breakdown of Internal and External Balance in the 1920s 2.1 Debt • The reparations provisions of the Treaty become a crucial impediment to growth . • These helped to cause the German hyperinflation of 1922-23. • Whether the hyperinflation was caused by the need to finance reparation payments, or whether the link was indirect – in that the Germany deliberately postponed balancing the budget in the hope that the resulting chaos would cause the reparations to be renegotiated. • The Dawes plan of 1924 led to US lending to Germany without dealing with the overall liability – the idea was to secure a schedule of payment, within which lending could be resumed, in the hope of an ultimate payment. • This lending provided the basis for German recovery in the period from 1924 to 1928. • Investment began to fall in 1928 and the growth process began to slow significantly • This happened under the shadow of a lack of clarity about how the reparations would be dealt with. • There is some similarity between what happened and the inability to wrote down the debt of peripheral Europe in present circumstances.

2.2 Adjustment Constraints • Britain emerged from the War without the capacity to sell enough to pay for its imports. Nevertheless there was a return to gold in 1925, at an exchange rate which most regard as about ten percent overvalued. The overvaluation of sterling and the high interest rates required to sustain it imposed a severe deflationary burden on the British economy. This is the most well known part of the story. • But Germany had returned to gold in 1924 – stabilising the new Reichsmark to the dollar at 4.20 to the dollar, an overvalued rate given the damage which had been done to the German economy by the war. • France returned to the Gold standard in 1926, at a highly competitive exchange rate, enabling France to grow through exporting, but adopted contractionarypolicies in a way which limited the monetisation of the surplus. • The US was in a competitive position. The US in the 20s was highly competitive but was unable to adopt the policies which would have damped the stock market boom and the housing boom of the late 1920s. • Put roughly the concern is that the gold standard caused policies in the first two countries – the UK and Germany - to be contractionary by 1930 – and prevented either adjustment in France or the damping of boom bust in the US in the late 1920s

Overall Global Aggregate Demand The gold standard did not contain within it a satisfactory mechanism for ensuring that the overall level of global aggregate demand was high enough. Only if that aggregate level of demand is high enough can one then concentrate on ensuring that there is a satisfactory adjustment mechanism which distributes that level of demand across countries in the appropriate manner. Roughly speaking, it appears that the problem with the gold standard was not just that the adjustment mechanism between countries was at fault. That is, it was not just the case that there was a difficulty of adjustingthe relative costs and prices of the countries in the gold-standard system. 2.3 Overall Global Aggregate Demand The gold standard did not contain within it a satisfactory mechanism for ensuring that the overall level of global aggregate demand was high enough. • This is necessary for adjustment, which distributes demand across countries in a manner consistent with longer term solvency. • The problem with the gold standard was not just that the adjustment mechanism between countries was at fault. That is, it was not just a difficulty in adjustingthe relative costs and in the gold-standard system. • There was a problem of aggregate costs-and-prices in the system: the absolute level of these costs-and-prices, averaged across the whole world, was too high relative to the absolute amount of gold in the global system. The inflation which followed World War I was what had caused this level of costs-and-prices to be too high in the world, relative to the supply of gold in the world. • The gold standard mechanism caused the deficit countries to contract without imposing on the surplus countries and obligation to expand. • The drying up of the loans to Germany by 1928 which had begun under the Dawes plan further dampened demand. • The response of the US to the currency crises of 1931 in Europe caused the downturn to turn into a depression

2.4 Summary • Internal and external balance between countries requires that the overall level of demand is high enough, and also requires that the relative competitive position of countries is appropriately adjusted so that this demand is distributed amongst the countries in the appropriate manner. The gold standard had two features (i) it required deficit countries to deflate, since they could not devalue their currencies, and it did not ensure that the surplus countries would expand in way which was symmetrical way to the way in which deficit countries were required to contract, thus tending to cause the overall level of demand to be too low (ii) it made the relative competitive position of countries difficult to adjust, since that would require a sustained period of underemployment and wage deflation in the deficit countries • In addition (iii) the overhanging stock of debt made investment risky and so made it all the more difficult to sustain a level of demand which was adequate overall. • This is a story about low growth prospects leading to an inadequate level of demand, made worse by the adjustment mechanism and by the overhang of debt. • Crisis is brought about in 1931 by the debt overhang in Germany and the inability of Britain to adjust in the face of the German crisis and the unwillingness of the US Federal reserve to sustain demand.

3 The Breakdown of Internal and External Balance in the Eurozone 3.1 The Supposed Framework - Growth and Integration • Until 2008, the establishment of the Euro was successful. High growth rates - high savings in the north, and rapid growth in the South. • The ambition was a reunification of Europe. The growth framework has some similarity to that described by Keynes in 1919, both in relation to saving and to regional integration.

3.2 The Supposed Adjustment Mechanism for Competitiveness The area appeared to be cushioned against economic shocks, and exchange rate realignments were a thing of the past. Within a monetary union wages and prices need to be set in the knowledge that each country needs to remain sufficiently competitive. The ‘Issing discipline idea’. External balance not needed each period, but long run solvency required. The ambition was the integration of credit markets, subject to the feature that risk premia would disappear thorough joining a common currency area. Fiscal discipline put in place through the Stability and Growth Pact (SGP), this was thought to be sufficient this assigned a particular (automatic) role to fiscal policy Private wage and price setting decisions and expenditure decisions thought likely to be stabilising. If so then SGP made sense.

3.3 A Fragile System Wide divergences in growth rates within the Eurozone. Capital flowed into the periphery - Greece, Italy, Ireland, Portugal and Spain, or the GIIPS – which experienced a boom. Countries of the North, led by Germany, grew much more slowly - a reflection of the high savings. As a result of these savings differences there were wide divergences in inflation rates; these were higher in the GIIPS countries and lower in the North. The emerging lack of competitiveness was endogenous to the system. • Absence of gold standard constraint in which external deficits lead to rising interest rates constraining the boom • By contrast Walters critique: countries in the periphery experiencing inflation had, as a result lower real interest rates which stimulated the boom A forward-looking private sector would safeguard against difficulties both in its wage and price setting decisions and in its expenditure decisions but a backward-looking private sector would not. (iii) Absence of any fiscal constraint on this process - because of SGP

The boom in the South and the saving in the North, and the emerging competitiveness gap between South and North, created current account imbalances Shock of the global financial crisis in 2008 created a downturn – very much similar to the US stock market crash in 1929. Exposed difficulties of macroeconomic adjustment to disequilbria similar to those of the 20s.

3.4 Debt The idea was that the emerging markets in the South of the Eurozone would provide investment opportunities – integration of capital markets would enable risk premia to fall. And they did fall, to zero, until 2007 After 2010, first for Greece and then for other countries, risk premia began to rise. • Sovereign risk premia – fear that given lack of competitiveness tax revenues would not rise again enough to enable sovereign debt to be honoured • Country risk premium – fear that given lack of competitiveness tax revenues would not rise again enough to enable country to become internationally solvent again unless currency devalued • Financial risk premium – fear that banks were insolvent and that sovereign would be required to accept this risk These risk premia were interrelated

3.5 Adjustment difficulties and overall aggregate demand How this process ends involves political choices • There is a cooperative solution • Or could see a slide into sovereign default and Euro breakup – mirroring what happened in the early 1930s. • Or, as at present, could attempt to muddle on, with very little debt forgiveness, with austerity, and with ten years of astronomically high unemployment. • It is not clear what the political consequences of that will be • It is not clear whether crises will be avoided

The economics of a cooperative solution is clear. • A mixture of further lending and debt writedown of sovereign debts and recapitalisation of banks (ii) An adjustment of relative costs and expenditures • Both Germany and Southern Europeans must switch their expenditures toward Southern European goods, • Germany must also agree to enjoy its creditor position by loosening its fiscal position. • Southern goods must become much cheaper relative to German goods, • this is difficult and slow within a monetary union (iii) Aggregate Eurozone expenditure maintained in a way which does not require an overall devaluation of the Euro relative to the dollar and the renminbi • Growth cannot resume without both of the first two objectives being achieved. Pursuing growth by the third means will create difficulties for the world as a whole which take us beyond this discussion.

Adjustment will take less time the more that Germany agrees to a greater expansion of German demand and to higher inflation in Germany. • Debts will grow and the debt write-down issue will become more demanding the longer that adjustment takes The extent of the write-down will depend both on the capacity to pay and on who ends up bearing the cost of the write-down. Issues include the recapitalisation of the ECB to deal with any write-down of its assets, and the extent to which lengthening of loans can stand in for debt formal write-downs.

4 Conclusion • As in the 1920s there is an underlying growth agenda • This growth agenda is being impeded by macroeconomic constraints • A solution has three aspects • Debt writedown and interim lending • Adjustment of relative costs and expenditures • Achieving a large enough growth in aggregate expenditures • As in the 1920s all three of these things much happen for growth to be resumed • The slower the adjustment until growth returns, the larger the debt buildup and the more debt that will ultimately need to be forgiven • Slow adjustment carries further risks – of default and crisis. • Cooperation is needed - to preserve political stability in Southern Europe during the adjustment and to reassure ordinary Germans that this is only a one-off, temporary transfer. • Such a one-off transfer was not possible after WWI but was made by the US after WWII

Lessons for now from the 1920s and 1930s