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Optimum International Policies for the World Depression 1929-1933 James Foreman-Peck, Andrew Hughes Hallett and Yue Ma University of Oxford, University of Strathclyde, University of Stirling ABSTRACT. The twentieth century’s biggest economic disaster, the world depression, could have been almost entirely avoided by a mix of fiscal and discount rate policy even in 1929. Where these two policy instruments were concerned, enlightened national self-interest, a Nash non-cooperative equilibrium, was more important than international cooperation or coordination. However abandoning the international commitment to the gold standard was not necessary for economic stabilisation. The conclusions are reached by simulating monthly econometric model of the interaction between the Unites States, Britain, France and Germany. Keywords: Great Depression, Policy simulation, International spillovers Published in Economies et Societes, Histoire quantitative de l’economie francaise, Serie A F, n 22, 4-5/1996,p219-242 1 This work was supported by ESRC grant number ROOO23l534. 1 Optimum International Policies for the World Depression 1929-1933 Midway between the two world wars stands the biggest economic catastrophe of the twentieth century, the depression that began in 1929. Without the mass unemployment of the Depression, the political extremism and state terrorism that precipitated the second war would have been avoided. A booming world economy in the decade after 1939, would certainly have ensured that the following years were more tranquil. Establishing the causes of the Great Depression might not however supply the lessons needed to avoid future economic disasters. Inevitably unpredictable shocks to the world economy will continue. Policies and institutions are needed to dampen such impulses. The present paper examines whether the coordination of international economic policy in the face of the shocks that precipitated the world depression could have alleviated or avoided the actual collapses of incomes, output and employment. We address this question by simulating a monthly econometric model of the interactions between the largest industrial economies; the United States, the United Kingdom, France and Germany, the 'G4'. Two other approaches have been more widely employed to address the causation of the Great Depression and the appropriate policy responses. Simple formal models have been used as parables or rhetorical devices to persuade audiences of the correctness of a diagnosis, but they are rarely robust to plausible small changes in specification. Moreover the extent to which they capture key characteristics of the economies modelled is inevitably a matter of opinion. Alternatively, understanding is sought by description of institutions, policies and events, in which the historian's "judgement" provides support for the counterfactuals. This approach has an in-built conservative bias; given all antecedent conditions to the Great Depression - institutions, beliefs of statesmen and speculators and so on - obviously events had to pan out as they did. Nonetheless informal historical description and judgement remains perhaps the most popular method because it is easier to communicate, it is less demanding of intellectual investment and it is more satisfying for those who see history merely as illustrations of pre-established ideological truths. The quantitative approach to history, exemplified by econometrics, combines the advantages of both the above alternatives. The mathematical structure allows the deduction of complex chains of cause and effect that may not otherwise be immediately apparent. And the obligation to fit the model to the available evidence provides an objective standard of descriptive accuracy. Unfortunately econometric attempts to analyse this period have typically been hampered by the small number of observations available from annual data, though more recently a few quarterly models have been estimated (Sommariva and Tullio, l987; Dimsdale, Nickell and Horsewood, l989). To increase the available degrees of freedom, it is worth utilising the available abundant monthly data, perhaps trading off more noise for a greater number of observations. Our work is the first multicountry model of the period not based on annual data. A second contribution is the computation of different counterfactual strategic policy equilibria from the parameters of the model. For this period the implications of such equilibria have previously only been considered theoretically. We conclude that, for United States, Britain, France and Germany (G4), abandoning the international commitment to the gold standard was not essential for economic stabilisation. Legislative, ideological and political barriers blocked expansionary monetary and fiscal policies that would have eliminated the depression in the four countries over the critical years 19291933. But that does not release statesmen from their obligations to confront these obstacles, 2 whatever the conventional wisdom. Ultimately domestic political failure, rather than the shock of the First World War, or the gold standard, underwrote the Great Depression. Enlightened national self-interest in economic policy was more important than international cooperation or coordination. We begin with an outline of structures of the four economies and the relations between them. We then discuss selected dynamic multipliers from the model later used to simulate strategic policy alternatives, so as to elucidate the model's properties. In the third section we consider the G4's policy objectives, instruments and options. Section four describes the model of strategic policy interdependence and section five presents some counterfactual optimal policy simulations. 1.The G4 Economies and Their Interrelationships The US was by far the largest economy by virtue of both higher living standards and larger population. Britain, France and Germany were little different from each other in size (Table 1). All of them were on the gold standard in 1929 and their ability to remain there depended on the value of their gold reserves among other things. Relative to national output and income France held by far the highest level of reserves, thanks to past history and the Bank of France statutes. Britain's low official reserves were higher than before 1914 but then a far larger cushion of income from foreign assets supported the balance of payments. Her dependence upon imports was considerably greater than the other economies and that may have made her reserves seem inadequate in times of international crisis. Germany's vulnerability stemmed from her high export/GDP ratio; closure of foreign markets would cut German output savagely. Table 1 G4 Economies in 1929 GDP Gold reserves/ (% of US) GDP (%) Exports/ GDP (%) Imports/ Gold reserves /Imports GDP (%) (%) 4.0 102.5 US 100.0 4.1 5.0 UK 23.6 2.7 14.7 22.4 12.0 France 17.3 10.5 11.1 12.8 82.0 Germany 18.5 3.6 17.0 16.9 21.3 International Capital Mobility Since capital flight was a prominent feature of the crisis of 1931 and after (James 1992), it is tempting to assume that capital was highly mobile in the interwar years in the sense of international macroeconomics; domestic interest rates do not and cannot diverge from foreign rates. However time plots and correlations suggest that was not so from month to month. British and American money markets, the two most liberal in the world and attached to the two richest economies, were closely linked from the time of the first successful Atlantic telegraph cable. 3 During the later 1920s American lending to Germany suggested increasingly close connections between those countries. Since the prohibition of German securities on the Paris bourse after the Franco-Prussian war, French and German finance had pursued independent courses, and continuing disputes during the 1920s reinforced that tendency. London traditionally stood at the centre of world financial movements but an overvalued exchange rate and shortages of gold, in striking contrast to Paris's position, reduced the influence of London on Paris and Berlin compared with the classical gold standard period. Interest rate correlations reflect the above account, even allowing for differences in the assets between economies (Table 2). Correlations were highest but by no means perfect on monthly data between London and New York, (correlation 0.77), second highest between US and Germany (0.63) and third, UK-Germany, at 0.47. Not wholly unexpectedly, but still striking, is the effectively zero correlation between Germany and France. Table 2 Monthly Interest Rate Correlations UK UK US France US 0.77 1927.1-1931.8 France Germany 0.30 0.47 0.35 0.63 0.01 Sources: UK- yield on day to day interest, Federal Reserve Monthly Bulletin, US- Yield on US short interest rate, Federal Reserve Monthly Bulletin, France- Paris private discount rate, Federal Reserve Monthly Bulletin /LCES, Germany- Day to day interest rate, Tinbergen 1934/ Derksen 1938 Time series of interest rates suggest French financial crises were largely independent of those of its three partners, though with Germany there was a sign of linkage in July 1927. But thereafter French blips in 1930 were not reflected in Germany's falling rates nor was Germany's July 1931 crisis mirrored in France. Floating rate behaviour may therefore have resembled that under fixed rates. Panics were exogenous, so there was little capital mobility in response to interest differentials. Trade Patterns Bilateral trade flows signal one source of vulnerability and power. Germany was vulnerable to French policy which could close a market but France was not similarly vulnerable to Germany (Table 3). Germany was particularly dependent on the British market. The US was also highly dependent but Britain was unlikely to choose a policy of cutting raw cotton from the US. So Britain appears as the country on which others depended for markets but she herself did not depend on them for sales to anything like the same extent. British export markets were in the wider world especially with primary product exporters. 4 Table 3 1929 Bilateral Export Proportions % Exports from Exports to UK UK France Germany 0 15.10 33.02 16.15 8.51 5.07 7.83 France 6.44 0 Germany 4.36 0.35 0 USA 9.30 8.76 8.39 R.O.W. 79.89 75.78 50.09 USA 0 70.96 Source; US and General Import of Merchandise (US), Commerce Special (France) Trade and Navigation Accounts of the UK, CSO UK Germany, like the US, imported more than four fifths from the rest of the world whereas two fifths of British imports came from the three partners and one third of the French (Table 4). Britain is therefore able to export more unemployment to the three than is Germany to its three partners. France exported 15% of her goods to the UK but imported 10% and was therefore more vulnerable. Table 4 1929 Bilateral Import Proportions % Imports of Imports from UK France Germany UK France 0 10.01 5.48 0 Germany USA 4.68 7.49 0.21 3.90 0 5.79 18.54 11.36 USA 15.65 11.69 12.41 0 R.O.W. 60.32 66.94 82.70 82.83 Source: as Table 3 Price linkages Despite the gold standard link, monthly domestic price levels in the four countries showed a good deal of autonomy. Although national indices are constructed differently, the general pattern seems robust. US prices peaked in 1928 quite independently of Britain's and turned down in 1929 4-5 months before the British. They also fell more steeply thereafter. Massive gold reserves allowed France to pursue a completely different course, with prices rising into 1931. German prices dipped in 1927 perhaps following a steeper French fall that was not apparent in Britain or the US. The German peak was rather similar to the US as was the downward slide from the summer of 1929, though the temporary recovery in mid 1930 was closer to British than to US experience. Contemporaneous correlation coefficients summarise this picture. They are larger than the interest rate coefficients because of greater inertia in price levels. 5 Table 5 Monthly Price Level Correlations US UK France Germany 0.94 US France 0.62 0.77 0.64 0.87 0.43 Note: US; price index of finished products FED/LNM: UK; Ministry of Labour cost of living: France; Paris retail price index LCES: Germany; cost of living. 2. Dynamic Multipliers of the G4 Model The above characteristics are encapsulated in the model employed to evaluate policy options during the Great Depression; essential that of Mundell/Fleming with a Nickell/Layard supply side for each of the four countries. There are three types of international linkages between them; prices, interest rates and trade volumes. An earlier but very similar version was briefly described in Foreman-Peck, Hughes Hallett and Yue Ma (1992). The present model differs only in the exchange rate equations, now based on Fisher et al (1990), and additional international price linkage equations. To examine the dynamic properties of the model we discuss selected multipliers, obtained from temporary changes in key policy instrument; interest rates and expenditures. We suppose a small change occurred in each of these variables in 1929 and in the following year these policy variables resumed their historical values. We then trace , through successive years, the response of GDP and the trade balance, both of the initiating economy, and of other members of the G4 (spillover multipliers). The values of the multipliers in each period may therefore depend upon a large number of parameters of all the economies in the system. In practice, as we shall see, the major effects are much simpler. The multipliers' principal purpose is to explain how policy works in this model. Dynamics, or timing usually matters in policy history and time series econometrics is suited to capture these effects, unlike comparative static models. There is a secondary interest in the multipliers as well. Simulation, from which the multipliers are derived, strictly cannot test a model because many different models may generate similar simulation paths. However the exercise can enhance, or detract from, the plausibility of the structure. Interest rate shocks Under fixed exchange rates GDP is very interest sensitive; it falls substantially in each country in response to higher rates (in the US by the greatest value and the most rapidly, consistent with that economy's strong commitment to market forces) (Fig 1). The simulations increase the nominal interest rate for one year by one percentage point. Prices in 1929 when the multiplier calculation begins, were not falling as they were to do later drastically, and therefore later hikes may have been even more draconian in their effects. Conversely the ability of interest rate policy to stifle economic activity is not necessarily matched by the scope for expanding activity when prices are falling; price declines place a floor under real interest rates. Trade balances 6 improve in each economy when interest rates rise, though in the US by little as a proportion of GDP. Interest rate spillovers between countries are all adverse and show a distinctive pattern. Britain's trade balance and GDP are vulnerable to US interest rate changes. As expected from the capital market linkages, British GDP and trade balance are hardest hit among the US's three partners. As a percentage of the much smaller GDP, Britain's trade balance deteriorates by more than the US percentage improves, but on a much larger GDP. France is not far behind. <FIGURE 1 ABOUT HERE> US interest rates are a powerful instrument for achieving domestic objectives, but the US is not substantially affected by UK interest rate policy. Germany is, by contrast. British interest rate policy is effective in turning round the British trade balance, though with a lag; the first year impact only matches the spillover from the US. The GDP impact is slower to act and rather smaller. French own interest rate effects on GDP are about half as powerful as America's and the trade balance impact is very slow to take effect. Spillovers are fairly small and also with long lags. German own effects are broadly comparable with Britain's, but the trade balance effect is slower and more lasting. Spillovers to France are greatest, but still modest. Expenditure shocks Turning to expenditure effects (Fig.2), increased government expenditure invariably raised GDP initially and worsened the trade balance. Spillovers were always beneficial at first. The French GDP multiplier was the largest on impact and the least persistent, spilling over most to Germany with a long lag. Germany's expenditure multiplier resembled the US's (which peaked at 1.1) but was a little smaller, not even reaching unity. Germany and France were major beneficiaries of GDP spillovers from the UK. The UK's own multiplier reached a maximum of 1.5 after two years. The immediate GDP spillovers from the US impacted most on the UK GDP, but after two years were substantially greater on France and Germany. Trade balance spillovers from the US also were initially greatest (though small) on the UK but slight before Germany took over two years later. The US's own trade balance (negative) effects are minimal whereas UK's are considerable after three years. The UK's spillover to France and Germany are also greater than the US's. France spills over to Germany more than Germany does to France, though each is closer to the other than to the UK or the US. France's trade balance deterioration from government expenditure is the most severe. <FIGURE 2 ABOUT HERE> 3. Policy Options: Objectives and Instruments These multipliers determine the effectiveness of instruments in achieving objectives. But economic policy objectives themselves were inseparable from political goals, to which they often took second place. The Versailles settlement cast a pall over Europe even in 1929, despite the Young Plan's apparent success in removing reparations payments from the political arena. Bruening still hoped to negotiate better terms and his domestic economic policy was predicated upon what signals it was necessary to send to the Allies about Germany's commitment to economic stability (Borchardt 1991 ch8). France put security from Germany at the top of the agenda and thus imposed a constraint upon economic cooperation in 1931 when it mattered 7 most. Obviously inflation at the beginning of the decade, most extreme in Germany, placed a premium on price stability. Yet by 1933 Roosevelt and his advisers were trying to raise prices. Employment was a concern in Britain and Germany throughout the twenties and became intense everywhere after 1929. Agricultural depression in the US during the later 1920s did not register in unemployment so much as in falling incomes and bankruptcies. Political pressures were nonetheless as strong as those to address unemployment in Britain and Germany, precipitating the Hawley-Smoot tariff of 1930. Links between economic and political disorder earlier in the twenties were strong in France as well as in Germany. In France, as well as Germany, they imposed a conservative biass upon policy and favoured the gold standard as the guarantor of stability (Moure 1991). Only after Poincare's stabilization of the franc did domestic gold and savings flow back into France. We include the current balance in policy makers' preferences on the assumption that policy makers valued staying on the gold standard. That also makes sense in the floating rate scenario. Policy makers wanted exchange rate stability and to avoid depreciation. The British imposed a tariff after floating the exchange rate because of their concern with the trade balance (Rooth 1993). Authorities' principal policy instrument under the Gold Standard was the discount rate, although open market operations to influence the money supply were used as supplements. Fiscal policy, which was not tried to any great extent, possessed the advantage that it did not beggar neighbours under the gold standard. The drawback was the widespread belief that national budgets needed to be balanced even where capital expenditure was concerned. That was why J M Keynes was eventually led to advocate a revenue tariff under the gold standard, giving rise to a "balanced budget" multiplier. Abandoning the gold standard, as Britain did in 1931, was for Temin (1993) the only way in which economic decline could be arrested. Only then could the connection between the domestic price level and the balance of payments be severed. Expansion supposedly would be met by currency crises. Conceivably high capital mobility would have precluded alternative policies, such as a public works programme of the magnitude (perhaps 2.5 per cent of GDP) espoused by Lloyd George or the Labour Party in Britain, under fixed exchange rates. In the present model capital mobility is not very high judging by the fairly low short run interest rate correlations. Instead capital panics stemmed from cumulative judgements or misjudgements of national financial positions. Some of these could be remedied. The British budget deficits could and should have been measured net of national debt repayment. Since they were not, they conveyed an erroneous impression of Britain's financial position, in particular in 1931. Roosevelt's New Deal was ineffective because it was too little and too late. State governments cut expenditure as the Federal government increased theirs, and even that rise did not acknowledge the decline in tax revenues with reduced US employment and incomes in the 1930s. The earlier policy of President Hoover, attempting to compensate for the Federal Reserve's contractionary stance, or rather its impact on midwestern farmers, was the Hawley Smoot tariff. It showed a lack of concern with the outside world, regardless of whether it promoted retaliation. What was needed was a policy with a positive spillover, given the accumulation and sterilisation of gold by the Federal Reserve (Wheelock 1991). French gold policy also needed reversing as Table 1 showed. Yet despite the containment of the French and German banking crises, no expansionary monetary policies were set in train. By enhancing the efficiency of monetary policy, central bank cooperation may have been able to reduce the severity of the slump. Because each economy's policy spilled over on to its trading 8 partners', cooperation that took into account those repercussions could allow the attainment of collective policy objectives at lower cost. In recognition of this dependency, during the later twenties the central bankers of the four major industrial powers conferred regularly to facilitate the operation of the gold standard. Montagu Norman for the Bank of England, Benjamin Strong for the Federal Reserve Bank of New York, Hjalmar Schacht for the Reichsbank and Emile Moreau for the Bank of France tried to agree cooperative policies, to alleviate the deflationary impact of the scramble for gold reserves (Eichengreen 1992). But international monetary cooperation was none too successful during the world crisis (Clarke 1967). Another attempt at increasing the supply of monetary cooperation was the new Bank for International Settlements (BIS). In 1929 the BIS was formed not only to manage German war reparations but also to institutionalise central bank cooperation and improve the operation of the gold standard (BIS 1930/1931). As befitted the world's central banker, the Bank of England, in conjunction with the BIS, organised international credits to blunt the impact of the internal difficulties of the Central European countries. Unfortunately the date of foundation was not auspicious for achieving the ends of the BIS, nor was the imbalance in the supplies of world gold reserves. Since monetary contraction was so marked a feature of the crisis, we need to know what was necessary to prevent and reverse it. Under a fixed exchange rate regime, with perfect capital mobility, there is very little monetary autonomy. An expansion spills over into the balance of payments, running down foreign exchange reserves. Once they are exhausted either the exchange must be abandoned or the monetary policy changed. But as we have seen, capital mobility was not perfect and high reserves anyway left a good deal of freedom to France and the United States. 4 Strategic Interdependence and Optimal Policies How much better could the G4 economies have performed and what policies were required? Were the major industrial powers in a sort of 'prisoners dilemma' in which the logic of national self-interest impelled them to pursue policies that drove each economy into a slump that could have been avoided by cooperation? We model this type of policy interdependence by considering policies obtained when each nation optimises, subject to the constraints imposed by the economy, a function in which ideal values of GDP, the consumer price index and the trade balance are those of 1929. Deviations from the ideal values impose penalties that increase quadratically. Each economy is allowed two instruments, the discount rate and the government expenditure/GDP ratio in some simulations, and one, the discount rate, the money supply or the gold stock in others. When choosing values for their instruments, policy makers in each economy are assumed to take the world economy, and policies of other countries, as given. When other policy makers in fact react, the first country re-optimises, once more taking the new values of its trading partner's policy instruments as parametric. This behaviour generates optimal reaction functions for each economy, in which their instrument variable value choices correspond to those adopted by other countries, (on the assumption that the trading partner will not then react again to the choices made by the first country). No weight is given to other 'players'' objectives in the calculation. Then all the reaction functions are solved simultaneously for the non-cooperative Nash equilibrium. The resulting set of instrument values determine the target outcomes to be expected. 9 The conventional representation of this solution is given in figure 3. Each country has its discount rate as instrument (R=domestic rate, R*=the foreign rate). The constrained welfare functions are U and U*, with indifference contours as marked and bliss points A and A*. They summarise each governments preferences between incremental changes in its policy targets (price stability and output growth, say), constrained by the economy's ability to deliver those changes. Welfare is monotonically increasing inwards perpendicular to each contour. That means the optimal choice for R, given each possible choice of R*, is determined along the domestic policy reaction function B. Similarly B* determines the optimal choices of R* given each value for R. The non-cooperative equilibrium is therefore that pair of values (R, R*) which satisfies both reaction curves simultaneously; N. <FIGURE 3 ABOUT HERE> Pareto optimal (cooperative) policy choices could be established at lower interest rates and higher utility (for both countries) along the contract curve AA*. The precise point chosen determines the distribution of the gains between the trading partners. Yet another policy equilibrium is at at S, which represents a Stackelberg solution where R exercises leadership. Given the R value, R* follows on its optimal reaction function and the domestic economy reaches the highest (selfish) welfare it can attain with that optimal reaction. 5 Simulations Each of the above policy equilibria are optimum in one sense. Our econometric model simulations suggest that historical policies were clearly sub-optimal. Pursuing selfish myopic (Nash) national economic policies that were optimum given the structure of the economy could have virtually abolished the world depression while maintaining the gold standard (table 6). For the three European economies only the discount rate instrument was necessary and for all four major industrial powers, fiscal policy was needed. Leadership in the Stackelberg sense by the United States (assuming the other three countries adopt Nash strategies among themselves) makes very little difference. Neither US target values deteriorate much nor do those of other countries substantially improve (results not shown here). The shocks in the model are the additive error terms in the equations which are set to zero in the simulations. The poorer the fit of each equation, the larger the presumed shock. Beginning in 1929 policy makers have no knowledge of future shocks but they know exactly the future values of the exogenous variables of the model. In each year they form a rational expectation of the values of endogenous variables their partners should choose in the current year and in future years. Each year these expectations are revised in the light of the previous years' outcomes - if the expectations proved exactly correct no revisions are called for. Discount Rate as the Sole Instrument We first consider the classic gold standard policy scenario, in which the discount rate is the sole policy instrument (Table 6). The results show that the gold standard was not the root cause of the problem; national policies were. With optimum Nash discount rate policies there is little difference between floating and fixed rate regimes. Both require virtually zero US discount rates for the three years 1930-1932, and very low French rates for the same period. Floating 10 rates allow national price movements to diverge rather more but they still fall in all cases, so that even with zero discount rates, real interest rates remain high. Non-cooperative discount rate policy, with or without the gold standard, cannot avoid the impact of shocks altogether, but it can substantially reduce it. <TABLE 6 ABOUT HERE> Optimum discount rate policy does not save the US economy because the fall in GDP is too great and the scope for cutting the discount rate, 2%, too small, even given large US dynamic multipliers. Little help can be expected from the small European spillover effects to the US. Europe however gains significantly from Nash optimal US discount rate reductions. The US spillover effects to the UK account for half the turnaround in GDP whereas the UK's own discount rate policy accounts for only one quarter. The direct effects of UK policy are small since the Nash discount rate in 1929 is 0.2% higher than in history and the 1930 rate is only 0.2% lower. The historical UK GDP figure shows a decline of 0.1% which becomes a rise of 0.5% in the Nash scenario. That leaves 0.15% of GDP in 1930 to be explained by spillovers almost entirely from Germany. Germany radically cuts her discount rate in the Nash scenario, from 7 to 3.6% in 1929 and from 5 to 3% in 1930. In short Britain in 1930 in a Nash optimal world is the beneficiary of more sensible self-interested policies pursued by the US and Germany. The biggest national turnaround is in Germany where lower German discount rates, 3 and 3.6%, account for the radical improvement in the GDP growth performance- from -4.18% in 1929 to 1.7% and from -4.65% to 1% in 1930. Bruening's deflation was terribly excessive. Prices fell in Germany so that real interest rates in 1930 would still have been around 9%. France's discount rate is 1.4% lower in 1930 and 0.7% higher in 1929. The principal French gains from lower discount rates in the Nash scenario for 1930-32 come in 1931 and 1932, where although there is still a downturn, the fall in GDP is reduced by 3.75% and 4.3%. A Nash optimal French policy in 1931 leaves half of the GDP boost to be explained by spillovers. US counterfactual cuts in 1930 and 1931 account for about one quarter of the counterfactual 1931 GDP change. The French run massive current account deficits in 1932 and 1933; their large gold reserves meant they could afford to do so. Like Britain, but to a lesser extent thanks to these reserves, France gains a great deal from the lower world interest rates justified by national self-interest. Discount rate and Government Expenditure as Instruments Discount rate policy does little to help the US, but fiscal policy does a great deal (Table 7). In history US GDP falls 9.87 % whereas in the simulation the decline is reduced to 1.76%. In both 1929 and 1930 counterfactual government expenditure to GDP in the Nash scenario with fiscal and monetary policy instruments is 2.6% higher than in history. The impact in 1930 is about 5.6% of GDP. <TABLE 7 ABOUT HERE> In addition there is the effect of discount rate changes . In 1929 the discount rate is 2% higher than the historical value, constraining GDP in 1930 by the one year lag multiplier of unity. But in 1930 the discount rate is cut virtually to zero, almost a 2% reduction (1.93), with an impact 11 effect of (1.93 X 2.2)%. So the total discount rate effect in 1930 is (4.25 - 2) = 2.25% of GDP. Since prices were falling at 2.5% in 1930 the real discount rate was still not particularly low when the nominal rate was virtually zero. The inability to set negative discount rates when prices are falling explains the Keynesian downgrading of monetary policy and the key role assigned to fiscal policy. The total discount and fiscal impact in 1930 is then 5.59% + 2.25% = 7.88%, compared with the Nash counterfactual difference of (9.87-1.76) = 8.11%. The remaining boost to US income in the counterfactual world comes from international spillovers which are on balance beneficial in this scenario; tariffs and exchange rate depreciation are eschewed, and expansionary fiscal and monetary policies are dictated by the need for internal balance. Since the US is large and Europe small these spillovers are also small. As a very approximate rule of thumb, average spillover multipliers are perhaps one tenth of own economy multipliers but they tend to have a more delayed and/or persistent effect. UK spending in the Nash scenario is higher in 1929 by 0.68% of GDP, which since the one year lag spillover to the US multiplier is nearly 0.1, raises US GDP by (0.68 x0.1 =) 0.068%. Any other spillover effects of comparable magnitude operate after a greater elapse of time. Persistence of policy shock effects for two or more year explains a substantial proportion of policy impacts. This is the opposite of the predictions of rational expectations models. Instead of being ineffective, policies are hard to optimise from year to year because of their persistent effects. Taking the Nash equilibrium as the representative non-cooperative solution, the largest decline in GDP of any economy is just over 2 per cent, for the US in 1932. This alleviation of the slump is achieved despite keeping the ratios of government expenditure to GDP and current account to GDP within about 2« per cent of their historical values during the simulations, to ensure the counterfactuals were attainable. That magnitude for expenditure corresponds roughly with Lloyd George's proposed programme in Britain. Moreover all current account deficits are consistent with each country remaining on the gold standard (maintaining a fixed exchange rate regime), given the size of its reserves. For Britain the 1931 deficit is reduced to 1.9 per cent from 2.27 per cent. Lower interest rates and fiscal expansion in the early years of the depression are largely responsible for avoiding the worst of the slump. Since inflation was never a threat, the main conflict of policy objectives might have arisen from a deterioration in the current accounts, but a general expansion would avoid the most of that difficulty. Money Supply as a Sole Instrument Not surprisingly, the US behaves more like a closed monetary economy, than a small open economy. Direct control of the money supply is effective in influencing the US price level, even though the Nash optimal nominal money supply falls in all years within the simulation period, except 1930. The current account deteriorates but not by much. The UK virtually avoids the depression in this scenario as well, assuming the reserves were available to finance a current account deficit in 1931 of 2.1 per cent of GNP. That permits the massive swing in nominal monetary growth to be attenuated. Germany's GDP rockets by 17 per cent in 1933 after falling between 1929 and 1931, yet the current account is in surplus in all years except 1929. Prices everywhere show less tendency to fall, but each country has its own pattern. Open market operations may be helpful because of greater reduction of volatility. Mainly however they 12 offset the liquidity crisis by retiring bonds. Merely lowering interest rates does not help cashstrapped banks and businesses when money cannot be borrowed anyway. 6. Conclusion. More appropriate monetary policies could have alleviated the Great Depression. That is an implication consistent with the frequently remarked upon maldistribution of world gold reserves, and the failure of France and the US to pursue expansionary policies, as the 'rules' of the 'gold standard game' dictated. Ideally the US would have controlled its money supply and so prevented price declines even before 1929. But failing that, lower discount rates all round were possible and desirable, without overt cooperation. Britain could have managed with the traditional policy instrument, the discount rate, to counteract almost completely the shocks of the Great Depression, because she avoided banking collapses. Her historical discount rate policy, even before abandoning gold in September 1931, was closest to optimal of the G4 countries. German historical discount rates were the most excessive. A mix of fiscal and discount rate policy could have largely offset the impact of the depression. Fiscal policies were especially necessary for the United States because of the nature and magnitude of the domestic shocks. International spillovers mattered a great deal for Europe because the US was so large. What was best for one economy was also desirable for its trading partners. Although one year shocks had small spillover multipliers, total impacts of sustained changes were cumulative and the optimisation exercise conducted here takes place over five years. There was no overriding need to leave the gold standard and adopt flexible exchange rates if some or all of the policies simulated here were feasible, once the political constraints were overcome. The additional complications of managing competitive depreciations were unnecessary for the discretionary policies that could have avoided much of the world depression. There was effectively no international prisoners' dilemma to hamstring optimum policies; policy responses merely needed to be prompt and enlightened. 13 REFERENCES Bank for International Settlements, (1930/31) First B I S Report Basle Borchardt, K (1991). Perspectives on Modern German Economic History and Policy, Clarke, S. V. O. (1967) Central Bank Cooperation 1924-1931, New York: Federal Reserve Bank of New York Dimsdale, N, Nickell S and Horsewood N (l989). "Real Wages and Unemployment in Britain during the 1930s", Economic Journal, 99, 271-292. Eichengreen, B (1992) Golden Fetters: The Gold Standard and the Great Depression, New York: Oxford University Press Fisher, PG, Tanna SK, Turner DS, Wallis KF and Whitley JD (1990). "Econometric Evaluation of the Exchange Rate in Models of the UK Economy", Economic Journal, 100, 1230-1244. Foreman-Peck, J, Hughes Hallett A, Ma Y (1992). "The Transmission of the Great Depression in the United States, Britain, France and Germany", European Economic Review, 36. James, H. (1992) "Financial Flows Across Frontiers During the Interwar Depression", Economic History Review 45 Aug pp594-613. Moure, K. (1991) Managing the Franc Poincare: Economic Understanding and the Political Constraint in French Monetary Policy 1928-1936 CUP Kindleberger, C. P. (1973). The World in Depression 1929-1939. Allen Lane Rooth T (1993) British Protectionism and the International Economy: Overseas Commercial Policy in the 1930s CUP Sommariva, A and Tullio G (1987). German Macroeconomic History 1880-1979, Macmillan. Temin, P. (1993). "Transmission of the Great Depression" Journal of Economic Perspectives 7 87-102 Wheelock D C (1991) The Strategy and Consistency of Federal Reserve Monetary Policy 19241933, Cambridge: Cambridge University Press . 14 Appendix Data Sources and Abbreviations FED: Federal Reserve Monthly Bulletin LCES: London and Cambridge Economic Service LNM; League of Nations Monthly Statistical Bulletin J Tinbergen (ed) (1934) International Abstract of Economic Statistics 1919-1930, International Conference of Economic Services (Brussels) J.B.D. Derksen, (1938) International Abstract of Economic Statistics 1931-1936, Permanent Office of the International Statistics Institute (The Hague) 15 Table 6 Discount Rate Policy Only. Discount rate instrument, gold standard, Nash equilibrium Discount rate GDP % growth Current balance/GDP Price level US 1929 5.0 5.5 0.9 0.0 1930 0.01 -5.9 0.7 -2.7 1931 0.2 1.6 0.01 -8.3 1932 0.3 -6.3 0.1 -8.4 1933 2.6 -0.1 0.4 -1.5 UK 1929 5.2 1.9 1.9 -0.4 1930 2.8 0.5 1.2 -8.0 1931 3.9 0.0 -1.8 -3.9 1932 4.3 -0.1 -0.4 -2.4 1933 3.0 0.1 0.6 1.4 France 1929 4.2 9.8 1.3 3.0 1930 1.1 1.0 0.5 5.7 1931 0.8 -0.5 -0.1 -14.3 1932 0.7 -2.7 -1.5 -8.8 1933 3.8 0.2 -1.9 4.2 Germany 1929 3.6 1.7 -0.3 -0.7 1930 3.0 1.0 1.0 -6.4 1931 3.4 -0.1 3.2 -7.0 1932 4.6 -1.4 -0.3 -7.2 1933 10.5 4.2 -0.4 5.8 Weights for GNP, CB are 1; for CPI are 0.5 (except US 30 31, Uk 30, Fr 31,32, Gr 30 ,31,32 are 1.) Weights for discount rate US (2,3.5,1,3,0), UK ( all 0) Fr (2,0,0,1,0) Gr (0,0,0,0,2). 16 17 18 19 20