Economic History Crash Course By Kenneth Creamer for ASRI Future Leaders Fellowship Program March 2016 Important episodes in recent economic history • Gold Standard (for centuries before being abandoned over time between 1913 to 1930’s) • Bretton Woods fixed exchange rates and formation of IMF and WB (c 1945) • Collapse of fixed exchange rate system (c 1971) • Deregulation and financialisation (c 1980’s and 1990’s) • The Great Moderation (c late 1980’s to early 2000’ s) • Great Recession (c 2008-09) Gold Standard • For centuries gold (and silver) played a key role in human exchange – facilitating international trade and serving as a store of value – gold was commonly accepted in Europe, Africa, the Middle East, India and China for centuries e.g. gold looted by Europeans from Latin America was used to buy good from China and the Middle East already in the 1500-1600’s • By the 1700-1800’s the fixing of the value of a currency to gold (eg USD20.67 was exchangeable for one ounce of gold) served to maintain the value of currencies (avoid inflation) and served to stabilise the economies of nation states as follows: – – – – If there is inflation, the export of goods become less competitive This produces a trade deficit (X<M) There would be an outflow of a country’s gold abroad The domestic money supply would fall (as gold holdings fell) and inflation would be contained • In the equation of exchange: MV=PY – M - Growth in Money supply is limited by size of gold holdings – V – Velocity of money is assumed fixed – P – Prices will only rise if M rises Y – total output is assumed fixed (at least in the short run) – (P anchored by M which is anchored by gold) Problem with gold standard • Being linked to gold limited the money supply and reduced the flexibility of governments to boost the money supply in order stimulate demand • The gold standard is one of the factors blamed for the Great Depression (in the US, UK and other countries) as it meant money supply could not be increased to stimulate demand, save failing banks and fund a fiscal deficit. • Policy errors are also blamed for the Great Depression in the US as the Fed did not respond to the falling money multiplier which meant that money supply was reduced exacerbating the depression. • Keynes the ‘father of macroeconomics’ labelled the gold standard “a barbarous relic” • He believed that in modern societies gold-backed money should be replaced by fiat money – money not based on gold, but based on government decree • Properly managed fiat money supply – would give full flexibility to deal with economic downturns, and would not be inflationary if properly managed • Badly managed fiat money - can lead to hyperinflation and very negative economic outcomes. Keynes and macro stabilisation • Keynes was a proponent of macro-economic stabilisation policies given his view that capitalist economies were inherently unstable and that intervention was needed at times of falling investment in order to avoid high levels if unemployment, etc. • Keynes’ approach dominated from the 1930’s to 1960’s: • In the US – the New Deal (1930’s) – left the gold standard (1933), fiscal expansion, public works, building dams and infrastructure, bank regulation (Glass Steagall Act) • In Europe – the Marshall Plan – the reconstruction and development of Europe (post WW2) • Compare post WW1 (Treat of Versailles) with post WW2 (Marshall Plan): The Weimar Republic (post WW1) collapsed due to hyperinflation as money was printed to pay the bills of a government crippled by reparations payments required in terms of the Treaty of Versailles Bretton Woods system • After WW2 countries agreed to a new international monetary system – with the aim of (1) facilitating a stable system of international trade and (2) rebuilding the world economy after WW2 • To facilitate international trade (capital flows remained highly regulated): – The US would again peg its currency to gold (USD35 per ounce) and and all countries would peg their exchange rates to the US dollar, but it allowed for adjustments to be made to these pegs (to avoid the inflexibility that had come with the gold standard) – Countries would not be allowed to embark upon competitive devaluations (in more recent times referred to as ‘currency wars’) – Monetary policy should maintained to ensure that currencies stayed with 1% of their pegged value e.g. • if there was inflation in a country then this would tend to cause a depreciation (as exports are less competitive and imports are more competitive), • in order to avoid a depreciation the country would have to use its holding of reserves to purchase its own currency and • the money supply would fall and inflation would be contained Bretton Woods system • To assist in rebuilding the world economy, new institutions were set up: – The World Bank (then called the International Bank for Reconstruction and Development), and – The International Monetary Fund (The IMF) • Note: The WW2 victors dominate the positions of power in the UN and in the WB and IMF (this has become a major issues of political contestation) Collapse of Bretton Woods • The fixed exchange rate aspect of the BW woods system ended in August 1971 when the US unilaterally left the system • The US need to devalue it currency and could not under the BW system • The US needed to devalue as it was importing more than it was exporting and it had rising national debt (not least due to the cost of the Vietnam War) • The BW system of pegged-exchange rates was replaced by a ‘non-system’ of floating exchange rates Rise of monetarism • In the 1970’s there was stagflation, economic stagnation (low growth) combined by inflation driven in part by the Opec Oil shock • The collapse of the BW system of pegged exchange rates meant the international monetary system was based on fiat money with the US dollar as the reserve currency • Monetarists (led by Friedman) replaced Keynesians as the dominant force in macroeconomic policy making – the emphasis was on controlling the money supply – allowing it to grow by an x% - in order to contain inflation • The monetarist doctrine being that “inflation is always and everywhere a monetary phenomenon” • This non-interventionist ideology, which assumed the inherent stability of the capitalist system, fed into the rise of neo-liberalism, neo-conservatism and economic deregulation in the 1980’s and 1990’s (which was further reinforced by the collapse of the Sovietbloc of countries in the late 1980’s and early 1990’s) Deregulation and Financialisation • • • Writers like Wolfgang Streeck see a series of related crises over the 1970’s – from inflation to public debt to financialisation Inflation was brought under control after the Volcker shock of 1979 and in the 1980’s As inflation receded, public debt begun to increase, because: – – – • • • • • • Taxes revenues received by govt’s fell (as growth fell) and expenditure by govt’s rose due to social assistance needed to compensate the rising numbers of unemployed Therefore govt’ begun to borrow heavily as “Public debt turned out to be a convenient functional equivalent of inflation, as public debt made it possible to introduce resources into distributional conflicts” Forms become fetters – the accumulation of public debt cannot go on forever as it will drive up interest rates, and limit growth, and a growing share of public spending will have to be devoted to debt servicing, Therefore a new mechanism had to be found to manage social conflict which included “fiscal discipline” but gave resources for growth – this is the political economy origin of the financial deregulation of the 1990’s (such as repeal of the Glass-Steagall Act in the US) Private debt replaced public debt as the financial markets were deregulated and were expanded “Instead of govt borrowing money to fund equal access to decent housing, or the formation of skills. It was now individual citizens who, under a debt regime of extreme generosity, were allowed.. to take out loans at their own risk to pay for their education or to move to a less destitute urban neighbourhood.” The rich benefited – as they were spared increased taxes (as spending was contained) and they invested in financial services bubble (see rising share of earnings of the top 1%) The poor seemed to benefit (but did not) – as access to cheap money and sub-prime mortgages become a substitute for reduced social protection and labour protection as the labour market become ‘more flexible’ Rising inequality – a global phenomenon Drivers of Deregulation and Financialisation • There were two key drivers of deregulation and financialisation: – A rapid rise in cross border capital flows – The loosening of rules and restrictions on banks and the financial sector Rising Capital Flows • A rapid rise in cross border capital flows followed the collapse of the BW system of pegged-exchange rates • The value of capital flows – typically the purchase of assets such as stocks and bonds has come to far outweigh the amount of resources involved in the trade of goods and services • These are known as hot money flows, as distinct from Foreign Direct Investment (FDI) which enters a country • The key consequences of these rising capital flows have been: – Rapidly rising liquidity in international financial markets – This liquidity amplifies the size of crises when they do occur – Has increased the interconnectedness of the global international economic system • (Note: Some have argued the need to regulate these capital flows, but others have argued that the potential benefits which they bring outweigh the potential costs) Loosening of rules on financial sector • In 1999 the Glass-Steagall Act of 1933 was repealed (New Deal programme after banking crises of the Great Depression late 1920’s early 1930’s) • The Glass-Steagall Act had provided for a strict separation of investment banking and commercial banking • Under the Glass-Steagall Act depositors money could not be used by commercial banks to invest in high risk securities (this would have been the preserve of investment bank who were taking risk-taking investors money and chasing high return) • The repeal of the Glass-Steagall Act took away on important regulatory pillar of the process of financial intermediation which matched that riskaverse depositors (with govt-backed deposit insurance) with low risk (lower return) types of investment and disallowed depositors funds to be used in the high risk-high reward “casino” of Wall Street-style investment banking (with its new fangled financial products characterised by opacity and false ratings) • This deregulation seemed to work well in creating economic dynamism and financial innovation, but it sowed the seeds for the 2008-09 financial crisis and Great Recession that followed (A process of re-regulation has been undertaken e.g. led by Paul Volker in the US) The Great Moderation • The period in the late 1980’s to early 2000’s has been described as the Great Moderation • In rich countries business cycles became less intense and inflation rates moderated around the world • Part of the reason for business cycles becoming more moderate is believed to have been due to improved macro economic management – rather than Keynesian demand management policies which ran the risk of being pro-cyclical, inflation targeting policies focused monetary policy on a more reliably established mechanism of using Central Bank control over the interest rate in order to keep inflation on target • China’s modernisation and integration into the world economy (led by Deng Xiaoping) created a new engine of growth and assisted in pushing down inflation due to the entry of millions of lower paid workers into the global system of production (in addition to China, Eastern Europe and many other emerging market economies linked in to global production systems) • During this period, there was a view that the commodity cycle had entered a ‘super cycle’ and that commodity prices would remain high for a very long time Paradox that stability leads to risk taking • Minsky – calm before the storm – paradox that stable conditions create the environment for greater risk taking • There were conditions of tranquility - low inflation – and under these conditions, levels of debt of households and banks increased dramatically • Extreme financialisation occurred - a rise in household and bank debt fueled booms in asset prices • US house prices rose by 90% between 2000Q1 and 2006Q1 • Two views amongst macro-economists: • Predominant view at the time – CB’s should not lean against asset price bubbles by raising interest rates, but instead should “focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion” (Alan Greenspan 2002) • Minority view at the time – There have frequently been periods in history where low stable inflation has coincided with the build up of private sector debt that sowed the seeds for future banking crises (Borio and White 2004) Great Recession • The Asset price bubble burst in the US, UK and EU in 2008-09 • A financial instrument at the center of the 200809 financial crisis (watch the movie called The Big Short) was the mortgage-backed security (based on sub-prime loans that had incorrectly been rated as AAA safe investments) • When these securities lost there value this put pressure on bank balance sheets and many banks had to be bailed out • The crisis in the financial sector transmitted job losses, falling investment, falling growth, etc. to the wider global economy Policy responses to Great Recession • The policy response in the US was: – Fiscal Expansion (rising national debt), – Unorthodox monetary policy, such as QE – Re-regulation of the financial sector (led by Volker in spirit of Glass-Steagall Act) • The policy response in the EU and UK was: – Some fiscal expansion, but then a move to austerity (to avoid rising debt) – Now adopting QE, expansionary monetary policy – EU is complex because different governments involved with different priorities and problems, but only one monetary policy decided by ECB (e.g. Germany growing exports vs Greece having no exchange, rate, fiscal or monetary instrument to boost its economy and being advised to carry out an internal devaluation by cutting wages and benefits) Policy responses to Great Recession • The policy response in SA (similar to other BRICS countries): – Very low growth in SA (exacerbated by low growth in our trading partners and very low commodity prices) – Fiscal expansion, but leading to rising indebtedness and risk of downgrade, now accelerated fiscal consolidation (public sector wage v investment problem) – Monetary policy – SA has had historically low interest rates in recent years, but now rising with risk of stagflation and as the international interest rate cycle starts rising (led by US) – Difficulty of implementing supply-side reforms – more efficient state owned enterprises (shortage and rising cost of electricity), efficient service delivery and expansion of pubic infrastructure, avoid monopoly dominance by firms, debates on minimum wage and labour market reforms, etc.