Download Optimum International Policies for the World Depression 1929-1933

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
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This work was supported by ESRC grant number ROOO23l534.
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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,
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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.
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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.
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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.
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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
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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
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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
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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.
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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
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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).
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