Download The Return to Gold: Europe in the 1920s

Europe Between the Wars:
the Economics of the
1920s and 1930s
Off of Gold
• At the beginning of World War I, there is a panic---people run to the banks demand gold in all
countries & countries at war have gold being
shipped out.
• Central banks begin to run out of gold
• All belligerents go off the Gold Standard but they
promise to return to the prewar parity
• Refuse to convert notes into gold----so Bank of
England/Bank of France/Reichsbank notes are
“fiat money”
• Money creation by printing more currency and
open market purchases of bonds
• Currencies are allowed to “float.” The market
determines their value not gold.
Depreciation of the British pound sterling 1914-1919
$/£
Supply
$4.86
$3.20
Demand
1913
1919
Quantity of £s
Why do countries promise to return to
the “prewar parity” (UK: £1 = US$4.86)
• Why was the gold standard appropriate in
the 19th century?
• Long-term price stability, financial stability
• Fiscal discipline of balanced budgets.
• Reassures holders of debt they will be
repaid in full.
• Return to gold requires substantial
deflation to allow return to prewar parity
The Hopeless
Case:
Germany after
the
Hyperinflation
1923-1924
Germany: the Hopeless Case
No Return to Gold: “Start-Over”
• Hyperinflation ends in 1923
• Value of all nominal liabilities and assets wiped out--savings account to mortgages.
• New currency in November 1923 Rentenmark replaces
the Reichsmark, converted at 100 trillion to one, losing
11 zeros. $1 = RM 420,000,000,000
• Germany goes back on gold on a new parity where $1 =
RM 4.2
• Strengthened by Dawes loan of US$800 million to
finance Reparations.
• Reichsbanks begins operation with ¾ gold and ¼ foreign
exchange reserves.
Germany’s
Recovery Begins
• New Reichsbank under
Hjalmar Schacht sets a
tight monetary policy
• High interest rates so that
Germans not tempted to
flee new currency and
foreign capital is
attracted.
• Germany recovery begins
in 1924.
• But trust in new
government is weak
But……
• No other country has the excuse that they
had a hyperinflation that made their
currency worthless, wiping out the value of
all bonds, savings accounts, and all
debts…….
• So others have tough decisions to
make…….
Britain after World War I
• Britain at outset of World War I was committed to return to gold
at prewar parity.
• The British had experience in Napoleonic wars—Britain had
gone off gold in 1797 and returned in 1821. Long-term interest
rates had stayed low because public believed that inflation
would be reversed. Faith that government would do it again.
• [Example: £100 face value consol = P, coupon C = £3 per year
and i = yield. P = C/i £100 = £3/.03. If price level doubles
that means that in real terms the value of the coupon is
halved £1.50. Price level must drop to restore yield.]
• Pressure from the City of London. Desire to restore London’s
prewar position as the world’s financial center.
• The official Cunliffe Committee Report in 1918 accepts idea of
return to prewar par.
• John Maynard Keynes criticizes a return to par—deflation too
costly for anyone with a contract---nominal wages must be cut.
No Immediate Return
• In 1920, £1 = $3.40, the market’s
evaluation.
• But by 1923 £1 = $4.70 after flight of
capital from Germany and continent during
hyperinflation and French-Belgian
occupation of the Ruhr.
• Labor government discusses capital levy--capital flight and pound sinks to $4.30.
In April 1925, the
government decides that
it is time to move back to
the gold standard.
Winston Churchill,
Chancellor or the
Exchequer, strongly
behind move.
Bank of England raises
interest rates to attract
foreign capital and
deflate economy.
Britain’s Dilemma
• 1913 £1 = $4.86 or £0.206 = $1
• Pound depreciates so £1 = $3.20 at low point.
• Government begins to contract money supply deflation and
appreciation of pound
• In 1925, exchange rate seem close enough and government
decides to return to prewar parity of £1 = $4.86, but there was not
enough deflation
• E = 0.206 £/$ [1/E = 4.86$/£]
• But at this time one ton of steel costs $100 in the U.S. and £22.6 in
the U.K. so at £0.206 = $1 then, the U.S. steel costs in Britain
($100)(.206£/$) = £20.6
• Compare prices? British steel £22.6, US steel £20.6
• £ is overvalued, British goods not competitive so:
• IM > EX => Balance of Payments Deficit => gold reserves drop
• Response of Bank of England by the “rules of the game” is to raise
interest rates. Result deflation.
• Pound overvalued by 10%.
British Consternation!
• Under a classical gold standard and playing by the
“rules of the game” deflation should lower prices and
restore balance of trade. IM = EX.
• However, Surprise!
• Prices and wages prove to be “sticky,” the economy
does not behave by 19th century rules!!!
• In 19th century, when prices were falling, many
workers had contracts where they agreed to accept
lower wages. Especially in the coal industry, as well
as others.
• After war---and considerable sacrifice---workers
resist.
The General
Strike
• In 1925 the mine-owners
announced that they intended
to reduce the miner's wages.
Trade Union Congress
promises to support miners.
• The Conservative Government
does not back mine-owners and
decided to intervene, providing
money to bring the miners'
wages back to their previous
level. The Prime Minister stated
that this subsidy to the miners'
wages would only last 9
months.
• A Royal Commission
investigates. It recommended
that the industry be reorganized
and the Government subsidy be
withdrawn and miners' wages
be reduced.
• Miners refused---they are
locked out of mines by mineowners. TUC declares a
general strike.
General Strike 1926: armed
escort for food convoys
• The subsidy expired in May
1926, and the Tories led by
Stanley Baldwin and
Winston Churchill refused to
renew it.
• Mine owners slashed wages
and extended the working
day. The miners’ union
resisted and asked the TUC
for support. The General
Strike was the result.
• Eventually TUC gives up
But British wages and prices don’t
fall enough
• Coal, steel, shipbuilding and textiles, the 19th
mainstays of British industry are depressed
industries.
• Unemployment concentrated in North of
England, Wales and Scotland.
• Loss of export markets during war
• Priced out of market by return to gold at prewar
part.
• During 1920s, British unemployment remains
above 10%, though compensated by generous
unemployment benefits.
• British economy performs very poorly, low
growth and high unemployment 1925-1929.
British
Performance
France Comes Close to Disaster
• France continues to be dependent on short-term
borrowing to cover its budget deficit---that persists after
the war.
• By 1923 Budget Deficit = 31% of spending.
• Government unable to persuade Parliament to raise
taxes---hope that Germany will pay reparations and
solve the problem of the debt.
• New short-term bonds issued, but public lacks
confidence---result high interest rates.
– Bank of France buys bonds to keep rates low, adds to money
supply and to inflation, rates continue to rise
– Capital flight. Fearful of inflation, investors send money abroad,
worsening balance of payments deficit.
• The Franc depreciates: 1913 25FF = £1, Spring 1926
90FF = £1, then May 1926 170 FF = £
• Fears of a French Hyperinflation.
• In the crisis, Raymond Poincaré
becomes prime minister and
finance minister.
• He lowers income taxes to gain
confidence of wealthy and
proposes new general taxes.
Capital flight ends.
• Franc recovers slowly
• Decision NOT to force a
deflation and NOT to return to
prewar parity of 25FF = £1 and
5FF to US$1.
• Belief that deflation would ruin
French industry and agriculture.
• New parity £1 = 124 FF
“Franc Poincaré”
France’s Belles Anneés
•
•
•
•
•
•
•
•
•
•
•
1913 £1 = 25FF or 5FF = $1
Postwar depreciation of franc with inflation
In 1926, French government sets the new parity of £1 = 124 FF
E = 124 FF/£
But at this time one sewing machine costs £100 in the U.K. and
11,000 FF in France, so at £1 = 124FF then, the British sewing
machine costs in France (£100)(124FF/£) = 12,400 FF
Compare prices in France? British sewing machine is 12,400FF,
French sewing machine is 11,000 FF
Franc is undervalued, French goods very competitive in France
and Britain:
France: IM < EX => Balance of Payments Surplus => gold
reserves rise
Response of Bank of France by the “rules of the game” is to lower
interest rates but not enough. Result? Expansion and little
inflation.
Rapid growth and falling unemployment---an economic boom.
French gold reserves swell.
Italy—Capricious Dictator
• Postwar poor economic
performance. Lira falls in
value from 25L = £1 to 150L =
£1, the recovers slightly
• Democracy is subverted in
Italy when Mussolini marches
on Rome in 1922.
• He wants to see a “strong”
lira—a sign of Italy’s renewed
greatness.
• His goal is the “cuota
novanta” or the quotation of
90 lire to the pound sterling.
• In 1926, with a loan from the
U.S. banks, the Banca d’Italia
has enough reserves and lire
is pegged at 90 L = £1
Italy’s Stagnation
•
•
•
•
•
•
•
•
•
•
•
1913 £1 = 25L or 5L = $1
Postwar depreciation of the lira with inflation
In 1926, Italian government sets the new parity of £1 = 90 lire
E = 90 L/£
But at this time, one hundred hats costs £100 in the U.K. and
10,000 L in Italy, so at £1 = 90 L then, the British hats cost in Italy
(£100)(90L/£) = 9,000 L
Compare prices in Italy? British hats cost 9,000L, Italian hats cost
10,000 L
Lira is overvalued, Italian goods are not competitive in Italy or in
other countries. :
Italy: IM > EX => Balance of Payments Deficit => gold reserves fall
Response of Bank of Italy by the “rules of the game” is to raise
interest rates.
Result?
Slow growth and high unemployment.
Spain---the overvalued peseta
• General Miguel Primo de la
Rivera overthrows
parliamentary democracy in
Spain and rules as military
dictator 1923-1930.
• Sets the peseta at an
overvalued parity, so that it
is “strong.”
• Result?
Comparative Policies
Comparative Wage Inflation—and
Competitiveness
Comparative Performance 1919-1929
•
•
•
•
Total Increase in GDP, 1919-1929
UK 11% < Italy 18% < Germany 68% < France 79%
Interest Rates in 1928
UK 4.5% Italy 7%, Germany 7%, France 3.5%
• US growth over the decade 41%.
• Huge Imbalances at the beginning—much bigger than
adjustments pre-1913.
• Adjustments are incomplete by 1929
• Thus, the interwar gold standard (1924-1936) is a fragile
system---unlike the classical gold standard of 1870-1913
Uneven Recovery to 1929
Real GDP
UK
France
Germany
Italy
Neth.
USA
1913
100
100
100
100
100
100
1919
101
75
72
111
112
116
1929
112
134
121
131
177
163
If real growth rate 2% or 3%, then potential GDP was
112 or 119 in 1919 or 140 and 165 in 1929
What Turns a Recession into a Great
Depression?
1. Structure of the System
2. Shocks to the System
• There were important shocks to the world
system, beginning in 1929.
• But there were some conditions that
predisposed world economy to a huge decline.
• Eichengreen points out four structural factors
–
–
–
–
1.?
2?
3?
4?
Eichengreen (1992):
Four Contributing Structural Factors
1.
Changes in the Composition of Production
1.
2.
2.
Britain: decline of traditional iron and steel, coal textiles and
shipbuilding (No. England & Wales and Scotland), rise of
chemicals, electrical engineering, cars (Southern England).
High regional unemployment.
U.S. Rise of consumer durables. Consumer durables and
investment are very sensitive to the business cycle. Problem
of installment payments—higher real payments, repossession,
no credit for lost payments.
Operation of labor markets
1.
Inflexible wages
1.
2.
2.
Rise of Unions---UK, Germany….but these not very
comprehensive after World War I.
Internal Labor markets—personnel departments—layoffs not
wage reductions. But only in the U.S.
Unemployment Benefits---relatively high in the UK and some
work disincentive but not enough to fully explain high
unemployment.
U.S. (Consumption 80-90%)
Eichengreen (1992):
Four Contributing Structural Factors
3. Operation of International Monetary System—
failure to treat gold standard as a collective
good
1. Domestic political constraints—lack of willingness to
make adjustments
2. International disputes—reparations
3. Incompatible behavior—violation of the “rules of the
game”
4. Pattern of International Settlements.
1. The U.S replaces (partly) the U.K. as center of
world capital markets.
2. Countries operate on smaller gold reserves and
“Hot” Money flows makes adjustment more difficult.
Gold Reserves of Central Banks: Results of
Over and Undervaluation of Currencies
Percentage Shares
1913
1925
1929
USA
26
44
38
UK
3
8
7
France
14
8
16
Germany
6
3
5
Italy
6
3
2
Shocks? 1. Tight Monetary Policy or 2.
Golden Fetters? 3. Tariffs and Quotas?
• Golden Fetters? A large deflationary shock or
financial crisis starts forces a country to defend
gold standard by deflation. Maintain Gold
Standard Conflicts with Goal of Full Employment
• Tight Monetary Policy? Was the U.S. monetary
policy too tight by choice---trying to deflate the
bubble on Wall Street and then preserve the
gold reserve. Stopping Bubble Conflicts with
Full Employment.
• Trade Policies---Beggar-Thy-Neighbor policies
starting with the Smoot Hawley Tariff in the U.S.
– First Round---You gain and your trading partner loses
– Second Round---You lose…and the rounds continue
The Great Depression
Real GDP 1913=100
France
Germany
Italy
1913 100
100
100
100 100
100
1919 101
75
72
111
112
116
1929 112
134
121
131 177
163
1933 109
123
108
127 164
115
1939 134
139
183
162 195
165
UK
Neth.
USA
If real growth rate 2% or 3%, then potential GDP was 112 or 119 in 1919
or 140 and 165 in 1929 or 170 and 222 in 1939.
How Did Events Unfold?
• The Countries with overvalued currencies--France, Netherlands, Belgium, Switzerland--gain gold reserves. Inflationary pressure for
them and deflationary pressure on other
countries.
• Asymmetric responses.
• Violation of the “Rules of the Game.” France etc.
try to sterilize gold inflows so it won’t have full
inflationary effects.
• U.K., Italy, and other countries forced to tighten
monetary policy raise interest rates.
Tighter Monetary Policy
• In response to gold outflows, U.S. raises
discount rate in 1928 from 3 ½ to 5%.
Appropriate as U.S. is a booming
economy.
• U.K. finds it difficult to raise rates with its
depressed economy, high unemployment.
A conflict between internal and external
goals. Continued loss of reserves. Briefly
gets the U.S. to lower its rates to prevent
gold losses.
U.S. Monetary Policy
U.S. Stock Market Boom
• Huge rise in the U.S. stock market, March 1929. Big
boom in high tech stocks. People borrow to invest. New
investors flood the market.
• Other lending dries up. Foreign loans to Germany,
Austria and Latin America cease----their investment falls
and they move into recession in 1929.
• Market booming. In July 1929, Federal Reserve raises
the discount rate from 5 to 6%.
• But U.S. economy beginning to slow. Result is
beginning of sharp recession in September.
• Stock market crashes in October 1929.
• Federal Reserve Bank of New York eases monetary
policy to save financial system but once crisis is over the
Federal Reserve Board forces a return to tight money.
Crisis in Austria, 1931
• Austria owes reparations and borrows heavily from U.S. and
France.
• 1928-1929 ends capital inflows--cannot borrow anymore.
• Largest bank, Credit Anstalt borrowed from abroad to lend at
home. Funds withdrawn, cuts lending. Bad loans wipe out
capital and it loses deposits.
• Central bank steps in to guarantee deposits
• Discovery of secret plans for Austrian customs union with
Germany---French withdraw their investments.
• Dual problem---1. run on the currency and 2. run on the
banks.
• Policy Dilemma---Central bank has only one tool---if it
lowers interest rate to help domestic crisis, the foreign crisis
worsens, if it raises interest rate to stop external crisis,
economy sinks.
• Reaction: ends Gold standard with capital controls and
blocked trading.
• Tight monetary policy continues, hope to return to Gold.
• Economy continues to decline
Crisis in Germany, 1931
• New American and other foreign investment ceases.
German growth slows.
• Germany’s short-term foreign capital = 3 times its gold
reserves in Reichsbank. Confidence is essential.
• Reichsbank raises interest rates.
• Many firms fail, including Nordwolle, its insolvency
threatens solvency of banks.
• Germany faced with a dual problem---1. run on the
banks and 2. a run on its currency. Dilemma—raises or
lower interest rate?
• Declaration of bank holiday and exchange and capital
controls = Germany abandons the Gold Standard
• Tight money continues, Germany hopes to return to Gold
and stay at 1924 parity
• Begins a Deflationary Policy---Economy continues to
decline
Gold Reserves of Central Banks
Percentage Shares
1913 1925
1929
1931
1935
USA
26
44
38
36
45
UK
3
8
7
5
7
France
14
8
16
24
20
Germany
6
3
5
2
1
Italy
6
3
3
3
2
Next Crisis? Britain 1931
• Country sliding into a recession. Large trade deficit.
Payments on debt from Germany, Austria and Hungary are
not made in 1931. Latin America defaults on debt.
Speculators withdraw funds. Loses Gold.
• July 1931, Bank of England raises discount rate by 2 points.
Shouldn’t this attract foreign capital and improve
competitiveness?
• Unemployment already 20%, economy slides further and NO
increased confidence, funds continue to be withdrawn.
• Speculative attack on the pound
• Britain leaves gold September 1931.
• Unlike Germany and Austria---UK allows its currency, the
pound, to float and to lower interest rates and follow an easy
money policy. No promise to return to $4.86
• Bank of England lowers interest rates
• Pound sterling depreciates by a third relative to dollar. Exports
competitive
• Economy begins to rebound
U.S. Depression
• Tight monetary policy continues through 1930 and
onwards---high real rates of interest. Consumption and
investment drop.
• Smoot-Hawley Tariff 1929---highest ever U.S. tariff sets
off retaliation---world trade sinks.
• Tight Money aims to preserve gold reserves to stay on
the Gold Standard
• Three Banking Panics: 1930, 1931, and 1933 result in
reduction in money multiplier: Monetary and financial
collapse.
• GDP falls 25% and unemployment rises to 20% in 1933.
• Huge loss of gold reserves.
• March 1933---new Roosevelt administration. Bank
holiday and suspend convertibility of dollar into gold—off
the Gold Standard
• Monetary policy finally eased
France and the “Gold Bloc”
(Belgium, Netherlands and Switzerland)
• 1931 when other countries in crisis France is
strong. Huge gold reserves and export surplus.
• Britain, U.S. and other countries devalue or
allow currencies to depreciate, France’s
competitive advantage decreases.
• 1933 France is in recession, with a budget deficit
and a trade deficit.
• Strict adherence to gold---slashes spending and
raises taxes- deflationary pressure. Economy
contracts.
• Finally France and the Gold Bloc forced off gold
in 1936.
General
Worldwide
Deflationary
Policies.
Can you pick
out:
Which
countries
abandon the
Gold
Standard and
When?
When do policies shift?
Late 1930s—an anemic recovery
• By 1936, all countries have abandoned the gold
standard.
• 1936, U.K., France and the U.S. create the
Tripartite Agreement where they informally agree
not to pursue more devaluations and to stop any
more limitations on free trade.
• Change prefigures International Monetary Fund,
and the World Trade Organization (WTO--formerly GATT) after World War II
• But less, than full recovery.
The Great Depression
Real GDP 1913=100
France
Germany
Italy
1913 100
100
100
100 100
100
1919 101
75
72
111
112
116
1929 112
134
121
131 177
163
1933 109
123
108
127 164
115
1939 134
139
183
162 195
165
UK
Neth.
USA
If real growth rate 2% or 3%, then potential GDP was
112 or 119 in 1919
Policy Legacy
• Problems generated by World War I were
not successfully resolved.
• Weak system hit by hard multiple shocks.
• 1930s a “lost decade”
• Failure of “laissez-faire,” “gold standard”
and “balanced budgets”
• Distrust of free market policies
• Distrust of globalization
Reaction
• Socialism and Government Intervention arises in
all countries---UK, France, Germany, Italy, US
etc.
• Government control or regulation of industries---prices, entry and production—the end of
laissez-faire.
• Deficit spending. Fiscal policy to stimulate the
economy. End of balanced budgets.
• Off the Gold Standard. Permits Central Banks
discretion to operate monetary policy. Focus on
output and employment not the gold reserves.
Inflationary bias to policy.
• End of Globalization. World Trade shrinks. End
of Immigration. Capital Controls—ends
international capital movements.