Download Interwar instability

From the Gold Standard to
Bretton Woods
Cornel Ban
The gilded age upstairs
The gilded age downstairs
Pre WW I according to
Got a problem with war?
ww1
• Gold was used to fund the war
• Its export was prohibited
• As governments issued fiat money (unbacked
by gold) to finance deficits, exchange rates
began to float and capital controls were
introduced, leading to currency depreciations
• Only the dollar was backed by gold
Versailles, Versailles
Ouch!
Post-WW1
• Britain loses prominence
• A key creditor, Germany becomes a debtor
• Democracy, unions and left parties made the
fiscal and monetary bases of the Gold
Standard unsustainable and demanded
flexible exchange rates to accommodate
shocks
Gold Standard versus democracy
Reintroducing gold convertibility
• Hyperinflation countries (Austria, Germany,
Hungary) move first
• Austerity and loans from the League of
Nations boost gold reserves to back the GS
• Central bank independence is strengthened
Why did GS 2.0 last only 5 years?
• The Great Depression triggered a deflationary
spiral leading commodity exporters to cut
reserve levels and then the money supply
• This led to demand to relax GS rules
(inflationary gold bans that ruined the par
values of currencies to gold)
Why did GS 2.0 last only 5 years?
• Banking crises in Austria and Germany depreciate
gold and forex reserves
• Convertibility is suspended and exchange controls
are introduced
• Where countries stay on gold, central banks sold
off reserves and increased interest rates
aggravating unemployment and adding to
pressures for devaluation>currency war ensues in
mid 30s
• Speculation on currencies remained
Germany’s Gold
• Run high inflation to cut war debt to the
French->hyperinflation->new currency tied to
real estate assets->another currency ends the
crisis, supported by US capital inflows
• 1929: US inflows end->higher interest rates
are useless following Fed’s higher interest
rates->collapse of foreign reserves->austerity
The Great Depression
Lets get this straight
• Recession: When your neighbor loses his or
her job
• Depression: When you lose your job.
Now seriously…
• Gross Domestic Product (GDP):
Comprehensive measure of the nation’s
output of final goods and services.
• Real GDP: GDP measured at a fixed price level
(i.e., inflation adjusted).
• Recession: Sustained decline in real GDP
(approximately two quarters).
• Depression: Very severe recession
How Great was the Great Depression?
• Real output (GDP) fell 29% from 1929 to 1933.
• Unemployment increased to 25% of labor
force.
• Consumer prices fell 25%; wholesale prices
32%.
Stock Market Boom and Bust
S&P Composite Index
35
Sept. 1929
30
25
20
15
10
5
July 1932
0
Jan-21
Jan-23
Jan-25
Jan-27
Jan-29
Jan-31
Jan-33
Jan-35
Jan-37
Jan-39
Commercial Bank Failures, 1920-2004
4500
4000
3500
3000
2500
2000
1500
1000
500
19
20
19
25
19
30
19
35
19
40
19
45
19
50
19
55
19
60
19
65
19
70
19
75
19
80
19
85
19
90
19
95
20
00
0
Nominal and Real Interest Rates, 1922-33
Percent
Real
Nominal
Great Depression
• Bank runs plus contractionary monetary policy
to defend the ratio between gold reserves and
the money supplycurrency runsdepleted
reservesexchange rate controlsoff gold
Neoclassicals
• If people save, the higher level of savings
leads to lower interest rates
• Lower interest rates should lead to increased
investment spending and demand stabilization
• Say’s law: a rational business will never hoard
money but spend it
• Booms and busts are inevitable
Keynesians
• Demand-driven
• Financial bust followed by underconsumption
and underinvestment
• As prices dropped, a liquidity trap followed: even
if the interest rate falls, investment dos not
increase because investors’ expectations of profit
are lowered by expectations that the fall in
consumption is long term
• Secular stagnation theory
• Only government spending can improve
expectations
Monetarists
• Money driven
• An ordinary recession is met with the
shrinking of the money supply, causing people
to hoard money and consume less, leading to
a large fall in output and emplyment
• the recession to morph into a depression
Austrians
• Easy money during the 1920s led to
malinvestment
Marxists
• Inherent instability
• Classism
The Collapse of World Trade
$ value imports of 75 countries
Why Did It Happen? Some Suggested Causes
• The stock market crash – end of the party
• Collapse of world trade – globalization in
reverse
• Monetary collapse
Bank Failures
• 7000 banks failed -- many during
“panics”
• Number of banks fell from 25,000 in
1929 to 15,000 by 1934
Possible Channels:
• Loss of deposits  decline in
expenditures
• Customer relationships broken 
harder to borrow
• Money supply contraction
The chart shows that 99% of the population received a
9% increase in their income, while the top 1% saw
their income rise by 75%.
1,230,000 Americans
80
70
60
50
TOP 1%
BOTTOM 99%
40
30
20
121,770,000 Americans
10
0
1929
31
US credits and the Great Depression
• US becomes main creditor to European
sovereigns and corporates
• To cool the speculative boom the Fed
increases interest rates in 1928; money flows
back in the US and interest rates go up in
Europe
• The sudden stop in capital inflows compresses
demand in Europe, forcing deflation there
The periphery seizes up
• Austria bails out the biggest bank while trying
to stay on gold-depleted gold
reservesmarkets fear devaluationcapital
flightexchange controls end the GS
• Hungary
• Germany: defended the GS reserves by
limiting credit until it triggered a banking crisis
Managed floating 30s
• Currencies values varies but governments can
intervene on forex
• Monetary reflation: Central banks cut the
discount rate recovery led by interest rate
sensitive sectors
• Devaluations were done in an orderly fashion
• Coordinated reflation impossible because of
different interpretation of monetary reflation
• Propelled protectionist measures
Bretton Woods
• Exchange rate stability
• Trade boom
Bretton Woods’ monetary system
• Pegged but adjustable exchange rates
• Capital controls
• IMF
• …but not Keynes’ Clearing Union
BW’s extra levees
• Interest rate caps
• Development banks
• Assets in which banks could invest were
restricted
• Financial markets were made to invest in
domestic strategic sectors
• Licensing for importers to control trade
imbalances
• Governments with full employment mandates
BW’s first cracks
• 1959: convertibility of currencies weakens
exchange controls
• Needed by US interest to guarantee its exporters
a level playing field
• Key for a multilateral trade regime
• But high interest rates needed to maintain
credibility were limited by the postwar
compromise: full employment and welfare state.
The solution: exchange controls and devaluations
BW in the convertible 60s
• How to finance trade imbalances?
• Weak currency countries: more generous IMF
assistance to increase their reserves to
counter the speculative flows brought by the
relaxation of controls
• Strong currency guys: you live beyond your
means!
Triffin’s bank run
• The system had a tendency to meet excess
demands for reserves through the growth of the
demand for dollars
• once foreign dollar reserves looked large relative
to US gold reserves made the system unstable,
• especially as the US foreign monetary liabilities
exceeded its gold reserves
• If foreigners saw this and tried to cash in their US
liabilities for dollars before the US was forced to
devalue, the gold: dollar parity would be
questioned