Download Global Financial Systems Chapter 2 Great Depression

The 1920s
Great Depression
Causes of the depression
Parallels with today
Global Financial Systems
Chapter 2
Great Depression
Jon Danielsson
London School of Economics
© 2013
To accompany
Global Financial Systems: Stability and Risk
http://www.globalfinancialsystems.org/
Published by Pearson 2013
Global Financial Systems © 2013 Jon Danielsson, page 1 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Book and slides
• The tables and graphs are
the same as in the book
• See the book for
references to original data
sources
• Updated versions of the
slides can be downloaded
from the book web page
www.globalfinancialsystems.org
Global Financial Systems © 2013 Jon Danielsson, page 2 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Build–up — The Roaring 1920s
Keep that phrase in mind, we
have seen, and will see similar
expressions
Global Financial Systems © 2013 Jon Danielsson, page 3 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Relevance for today
• The biggest economic crisis the world has ever seen,
before and since
• Clear policy mistakes were the reasons for the Depression
• Significantly changed how we see the economy
• And had a very strong impact on the crisis since 2007
Global Financial Systems © 2013 Jon Danielsson, page 4 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
1929 GDP per capita in constant 1990
dollars and global rank out of 52 countries
27
Japan
Norway
Venezuela
Uruguay
Germany
Sweden
Argentina
France
Denmark
Australia
United Kingdom
Netherlands
Switzerland
United States
18
17
14
13
12
11
10
7
5
4
3
2
1
0
1000 2000 3000 4000 5000 6000 7000
Global Financial Systems © 2013 Jon Danielsson, page 5 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
The roaring 20s
• Rapid economic growth (with some interruptions)
• First time most people had access to markets
• Credit markets played a relatively minor role compared to
now
• Rampant stock market speculation
• Stocks bought on margin
• Extremely high levels of leverage (often 10 times)
• Recession was starting in 1929
Global Financial Systems © 2013 Jon Danielsson, page 6 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Impact of WWI
• Relative position of countries changed
• UK is no longer the world’s leading nation
• But the US is not yet willing to accept the mantle
Global Financial Systems © 2013 Jon Danielsson, page 7 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
US lending
After the war the US was the main capital exporter
• US had a trade surplus after the war
• Loans to Germany to industrialize
• Help Britain to restore the prewar gold standard
• Lending dropped sharply after June 1928
Global Financial Systems © 2013 Jon Danielsson, page 8 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
World War I obligations
• War reparations, war debt, commercial debt
• Positions of governments
US Did not want reparations, wanted war debt back
from allies. It was willing to negotiate, but only
on bilateral basis
UK Wanted to cancel war debt, except what was
needed to pay US
France Wanted reparations. Have Germany borrow in
New York to pay France (resisted since Germany
was seen as high risk credit
• This caused considerable frictions throughout the 1920s
and beyond
Global Financial Systems © 2013 Jon Danielsson, page 9 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Currencies
• Germany back on the gold standard in August 1924 after
•
•
•
•
its hyperinflation
Disastrous attempts to turn back the clock (UK, May
1925), next slide
France suffered instability and speculative attacks
(1923–1924), then stabilized but too low a rate
The relative overvaluation of pound and undervaluation of
the franc caused serious frictions (discussed along with
currency wars elsewhere)
France operated a sensible policy for its own objectives
not considering the stability of the system or indeed
French capital abroad
Global Financial Systems © 2013 Jon Danielsson, page 10 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
UK’s mistake
• The Chancellor of the Exchequer, Winston Churchill, on
•
•
•
•
the advice of the Bank of England, and against the advice
of Keynes, put the UK on the gold standard at prewar
parity in 1925
Britain had suffered 40% inflation, sterling was hence
significantly overvalued
Continuous recession and austerity ensued until Britain
gave up in 1931
After which its economy boomed
This episode has strong echoes today and motivates
many current commentators on the crisis
Global Financial Systems © 2013 Jon Danielsson, page 11 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflation
• Deflation was a major problem in the 1920s and 30s
• A major culprit was the gold standard
• note echoes to the euro
• Deflation is much more costly than inflation
Global Financial Systems © 2013 Jon Danielsson, page 12 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflationary cycle
Prices
fall
Global Financial Systems © 2013 Jon Danielsson, page 13 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflationary cycle
Prices
fall
Creditors
prosper
Global Financial Systems © 2013 Jon Danielsson, page 14 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflationary cycle
Prices
fall
Creditors
prosper
Debtors in
difficulty
Global Financial Systems © 2013 Jon Danielsson, page 15 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflationary cycle
Prices
fall
Creditors
prosper
Debtors in
difficulty
Both delay
spending
Global Financial Systems © 2013 Jon Danielsson, page 16 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflationary cycle
Demand falls
Prices
fall
Creditors
prosper
Debtors in
difficulty
Both delay
spending
Global Financial Systems © 2013 Jon Danielsson, page 17 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Agriculture
• Agriculture ceased to be important in industrialized
countries from the mid–1850s
• However farming accounted for a quarter of total
employment in the US, and was important for many
countries like Canada, Argentina, Australia, Italy, etc.
• Overproduction due to restoration of production in Europe
whilst production increased elsewhere during wartime
• Prices dropped 30% from 1925 to June 1929, 9% in the
second part of 1929
• Stockpile increased by 75% in the same period
• Eventually they had to be sold, depressing prices further
Global Financial Systems © 2013 Jon Danielsson, page 18 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Commodity prices
200
Great Depression
Wheat
Cotton
Sugar
Rubber
150
100
50
0
1920
1925
1930
1935
1940
Global Financial Systems © 2013 Jon Danielsson, page 19 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
1928–1929
• Levels of farm debt and government debt very high
• Falling prices lowers ability to borrow
• Exchange rates came under pressure to depreciate,
competitive depreciations
• Buyers not sellers market — highly inelastic demand
• FX depreciation does not raise prices at home but lowers
them abroad
Global Financial Systems © 2013 Jon Danielsson, page 20 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflation
• Depreciations were deflationary
• But if one country cut back on supply, benefit reaped by
others
• Deflation spread from commodity to commodity
• Positions of banks and insurance companies loaded with
mortgages weakened
Surpluses, liquidity crisis, FX depreciation, bank failure, money
collapse
Global Financial Systems © 2013 Jon Danielsson, page 21 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Stock market and capital flows
• An increasing amount of US (and global) capital went
•
•
•
•
into the US stock market
Fed worried that rampant speculation was diverting
money from productive uses
It tightened monetary policy
US stopped exporting capital
This caused problems elsewhere, countries lost gold and
had to raise interest rates
Global Financial Systems © 2013 Jon Danielsson, page 22 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
US monetary policy
• An important decision was taken following a conference in
•
•
•
•
July 1927 to cut US interest rates
Objectives were to help the UK
And support agriculture
May have been appropriate for the non–financial sector in
the US but was highly stimulating for the stock market
(echoes of the Greenspan put)
Opposite monetary policy needed for the two main policy
objectives
Global Financial Systems © 2013 Jon Danielsson, page 23 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Great Depression
Global Financial Systems © 2013 Jon Danielsson, page 24 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
US GNP in constant prices and
unemployment
120 bn.
GNP
Unemployment
100 bn.
GNP
15%
80 bn.
10%
Unemployment
20%
5%
60 bn.
1925
1930
1935
1940
Global Financial Systems © 2013 Jon Danielsson, page 25 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
US net capital formation (investment) in
constant prices
10.0 bn.
7.5 bn.
5.0 bn.
2.5 bn.
0.0 bn.
−2.5 bn.
−5.0 bn.
1920
1925
1930
1935
Global Financial Systems © 2013 Jon Danielsson, page 26 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
1929 stock market crash
• European markets turned down earlier:
• Germany 1927, UK 1928, France February 1929, Austria
waited until 1931
• But the main place was New York
• Where prices and volume doubled in two years
• The main danger was not the prices or volume but its
dependence on the credit markets and its influence on
credit around the world
• But business was slipping, business cycle peaked in June
1929 in US, April in Germany, July in UK
Global Financial Systems © 2013 Jon Danielsson, page 27 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Dow Jones
350
250
150
50
1926
1928
1930
1932
1934
1936
Global Financial Systems © 2013 Jon Danielsson, page 28 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Schadenfreude
(pleasure at the misfortune of others)
• After the excesses of the previous years, people cheered
• It was the bankers that suffered
• They got what they deserved
• Banks allowed to fail
Global Financial Systems © 2013 Jon Danielsson, page 29 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
What to do
Clear the deadwood or help the markets?
• Moral hazard
• The Treasury secretary Andrew Mellon said “purge the
rottenness”
• President Herbert Hoover that lending to foreign
countries was “a loose cannon on the deck”
• Too dangerous to let the markets become illiquid or fail
• Same debate as today, or?
Global Financial Systems © 2013 Jon Danielsson, page 30 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Liquidity support after crash
• Immediately after the crash the New York Fed provided
•
•
•
•
over $1 billion in liquidity support to banks
Prevented the otherwise inevitable bank crisis
But generally the governors of the Fed opposed liquidity
support — maintaining the bubble had been caused by
too much credit and further easing would be disastrous
And the Fed stopped easing in early 1930, when the
economy was taking a turn for the worse
Note relevance for today’s policy debate
Global Financial Systems © 2013 Jon Danielsson, page 31 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Liquidity panic
• Withdrawal of money from New York caused large losses,
•
•
•
•
firms and investors cut spending
Mortgages in the US were typically un–amortized three-year obligations
Homeowners typically did not have the cash and rolled
them over, otherwise foreclosure
But now lending stopped and house prices crashed
Prices fall because of no lending, and no lending because
prices are falling
Global Financial Systems © 2013 Jon Danielsson, page 32 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deflation feedback
Production cuts
Stock prices ↓
Credit tightens
Bank
failures
Commodity
prices ↓
Import prices ↓
Global Financial Systems © 2013 Jon Danielsson, page 33 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Banking crisis in Europe
• The French government encourages French banks to pull
•
•
•
•
money out of Austria to prevent a pending customs union
between Austria and Germany (narrow political
considerations)
Run on Credit Anstalt in Austria, becomes a run on
Austria
Bank crisis spills over to Germany
And eventually to UK which starts losing gold
Incompatibility between gold standard and lending of last
resort
Global Financial Systems © 2013 Jon Danielsson, page 34 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Banking crisis in US
• Peculiar structure of US banking system, narrow banking
• No bank crisis in the US until December 1930, Bank of
•
•
•
•
United States bank run
No help given
Confidence in banks was undermined. People could not
tell if a bank was sound and started pulling their money
out
Domino effects as loans are called, scramble for liquidity
Bank credit collapses — money supply contracts
Global Financial Systems © 2013 Jon Danielsson, page 35 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Deterioration
Depression becomes Great Depression in 1931
• Prices fall, business can’t service debt, bankruptcies
• Deflationary psychology
• Consumption and investment spirals down
• 1932 worst year in the US
• But Britain leaves gold standard and escapes the worst
Global Financial Systems © 2013 Jon Danielsson, page 36 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Government reaction
• The Fed increasingly demoralized and unable to offer
•
•
•
•
•
response
Contracts money supply in January 1933!
Open market committee does not meet in February (when
the worst was happening)
President Hoover requests suggestions from the
Governors of the Fed on February 25, receives none
Bank holidays become widespread
Difficulties because Hoover was on the way out and
Roosevelt had not taken power. Nobody in a position to
make decisions
Global Financial Systems © 2013 Jon Danielsson, page 37 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Causes of the Depression
Global Financial Systems © 2013 Jon Danielsson, page 38 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Causes of the Depression
• Main causes
• trade policy
• monetary policy
• Other causes, including:
• lack of global leadership
• lack of international cooperation and narrow focus on
national interests
• foreign exchange instability
• bank failures
Global Financial Systems © 2013 Jon Danielsson, page 39 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Trade
Global Financial Systems © 2013 Jon Danielsson, page 40 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Tariffs
Tariffs increased in the 1920s
• Protect against exchange rate dumping
• Many international conferences tried to prevent this but
to no avail
• Republicans in the US strongly pro tariffs
• Conservatives in the UK strongly pro empire preference
Global Financial Systems © 2013 Jon Danielsson, page 41 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Trade restrictions
• Smoot–Hawley passed the US House of Representatives
on May 1929, signed into law June 1930.
• Let loose wave of retaliations (and opportunistic
copying)
• Most trade seized
• Countries ran into serious difficulties because they could
not export
• Result was that everybody was much worse off
Global Financial Systems © 2013 Jon Danielsson, page 42 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Reduction in trade 1929 – March 1933
rch
Ma
April
1929
Ma
y
ry
1930
rua
Fe
b
e
n
Ju
1931
1206
992
1839
t
De
ce
gu
s
Au
e
mb
r
July
January
2998
2739
1932
Se
r
be
pte
ve
m
mb
er
October
Global Financial Systems © 2013 Jon Danielsson, page 43 of 61
No
The 1920s
Great Depression
Causes of the depression
Parallels with today
Reduction in trade 1929–1933
Over 80%
70%-80%
60%-70%
50%-60%
Chile
Cuba, China, Peru,...
Netherlands, Greece, Brazil, Estonia, Spain,...
Denmark, New Zealand, Finland, Columbia,...
Global Financial Systems © 2013 Jon Danielsson, page 44 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Liquidity and Money
Global Financial Systems © 2013 Jon Danielsson, page 45 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
US money supply 1926–1941
M0
60
M1
M2
USD Billions
50
40
30
20
10
0
1926
1928
1930
1932
1934
1936
1938
1940
Global Financial Systems © 2013 Jon Danielsson, page 46 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
And ratios to M2
60%
45%
30%
15%
M0/M2
M1/M2
0%
1926
1928
1930
1932
1934
1936
1938
1940
Global Financial Systems © 2013 Jon Danielsson, page 47 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Policy
• Reconstruction Finance Corporation late 1932, for
•
•
•
•
•
•
bail–outs
Speaker of the House insisted banks using the fund
should be publicly identified
That caused runs, so others stopped applying
Important argument for support to be secret
By February 1933, widespread bank closures
Fed refused in March 1933 to sign off a federal guarantee
for bank deposits
Then President Roosevelt shut every bank in America for
more than a week
Global Financial Systems © 2013 Jon Danielsson, page 48 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Friedman & Schwartz critique
Mistakes of the Fed
1. It did too little to counteract the credit contraction
caused by failing banks.
2. The Fed actually reduced credit between December 1930
and April 1931.
3. When the UK abandoned gold, the Fed raised interest
rates
•
•
•
•
expected rush to convert dollars into gold
did stop the drain of gold
drove yet more banks into insolvency
Fed was in no danger of running out of gold, it held 40%
of global gold reserves and had more than enough to
meet its legal requirements
Global Financial Systems © 2013 Jon Danielsson, page 49 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
4. Only under enormous political pressure did the Fed start
undertaking open market operations in April 1932.
Unfortunately, this was too little too late and failed to
prevent a wave of bank failures in the last quarter of 1932
5 When rumors that the incoming Roosevelt administration
would devalue the dollar lead to a renewed flight from
dollars into gold, the Fed once again raised the discount
rate
The conclusion of Friedman and Schwartz has significantly
influenced policymaking in the ongoing crisis, and is a key
reason why central banks have provided significant amounts of
QE
Global Financial Systems © 2013 Jon Danielsson, page 50 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Why?
• Fed should have aggressively injected liquidity into the
banking system from 1929
• Friedman and Schwartz argued that it was the death in
1928 of Benjamin Strong, the Governor of the NYFed,
which caused the deterioration in Fed performance
• An alternative explanation maintains that this was
deliberate by the Fed, protecting the interests of member
commercial banks rather than the general economy, that
it was content with seeing non–member banks fail, so
that the relative importance of the Fed would increase
Global Financial Systems © 2013 Jon Danielsson, page 51 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Devaluation — Abandon gold
• Key to recovery was to make prices increase
• Prices increased, real value of debt reduced, businesses
•
•
•
•
more willing to borrow and consumers more willing to
spend
Roosevelt took US off the gold standard in April 1933 —
against the advice of all of his economic advisors
In the following three months wholesale prices rose by
45%, industrial production increased by 50%
“Monetary policy on booze”
Dollar eventually stabilized at $35 per ounce of gold
Global Financial Systems © 2013 Jon Danielsson, page 52 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Lack of coordination
• Many meetings, producing little
• Focus on narrow national interests
Global Financial Systems © 2013 Jon Danielsson, page 53 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
War debt and reparations — April 1929
conference in Paris
• France insisted on reparation payments even if Germany
had no ability to pay
“Almost all the great powers have been negotiating for months
about how many billions a year should be paid until 1966, and
thereafter until 1988, by a country that is not even in a
position to pay its own civil servants’ salaries the next day”
Felix Somary in report to the SNB
Global Financial Systems © 2013 Jon Danielsson, page 54 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Parallels with Today
Global Financial Systems © 2013 Jon Danielsson, page 55 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Influence of the Depression
• The Depression has been a key causal factor in modern
economic policy
• Many international institutions, policy, rules and
regulations and responses derive from the Depression
• Bretton–Woods (IMF and WB), GATT and WTO
• The policy response to the crisis since 2007 directly draws
from the Depression lessons — especially the 2007–2009
phase
• Less so in the sovereign debt crisis
Global Financial Systems © 2013 Jon Danielsson, page 56 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Parallels and differences with today
• Period of credit expansion before crisis
• roaring twenties and great moderation
• Rapid financial developments, Wall Street increasingly
important for Main Street
• Bailouts very limited in the US in the Depression, more
widespread now
• Protectionism rampant then, mostly prevented now
Global Financial Systems © 2013 Jon Danielsson, page 57 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
• Currency wars common then, mostly prevented now, but
one is building up
• International coordination seriously lacking in the
Depression, very effective now
• Widespread bank failures then, not now
• Liquidity contracts (in the US), massively expanded now
Global Financial Systems © 2013 Jon Danielsson, page 58 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Lessons learned in 2008
• Broadly speaking governments are cooperating
• Banking is maintained
• Trade restrictions are avoided
• Liquidity is supplied
• Extensive cooperation
Thus the crisis did not become the Great Depression
Global Financial Systems © 2013 Jon Danielsson, page 59 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
Parallels with the sovereign debt crisis
• EU authorities very slow to react
• No single view
• EU seems badly equipped to deal with crises
Kissinger quipped about whom could he call in Europe when
there was a crisis
Global Financial Systems © 2013 Jon Danielsson, page 60 of 61
The 1920s
Great Depression
Causes of the depression
Parallels with today
• Gold standard is in some ways similar to the euro
• Going off the gold standard helped in the Depression — a
similar policy might help the crisis countries
• The austerity now is criticized with reference to events
then, especially in the UK between 1925 and 1931
Global Financial Systems © 2013 Jon Danielsson, page 61 of 61