Could summer 2010 reprise summer 1931?

In an earlier post I argued that Greece cannot grow within the EMU. It must default/ restructure and re-issue the drachma. The costs of exit are outweighed by the costs of staying on the euro. Markets have a short memory, and in fact Greece as a sovereign borrower will be more attractive post-default (because of a lighter debt load). Russia and a slew of post-communist countries managed to restructure their debts and return to the markets in short order. The burden of an overvalued currency is too high. Argentina in the 1990s pegged the currency to the dollar in a particularly onerous medium (a “currency board”). When the situation turned adverse (Asia crisis 1997), there was little serious consideration of leaving the currency board (i.e. 1-for-1 peg to USD). Argentina clung to its overvalued currency for four more years, suffering steeply negative GDP growth. At the end of 2001 it devalued and defaulted. Growth accelerated to 7.5% and stayed there till the recent global downturn.

Another precedent for the EMU travails is the Great Depression. The point of my original thread was that the medicine being prescribed during the Depression was austerity.

In this post I note parallels between 1931 and 2010. The global business cycle peaked in 1928, three years before 1931. The cyclical peak from which we are currently falling was 2007. As the cycle turns down, the weakest debtors begin to default, in a process explained cogently by Hyman Minsky (a good introduction by Pimco’s Paul McCulley is here). Sovereign credits began to sour in the current cycle with Dubai’s default in autumn 2009 and then the Greek rescue was arranged in May 2010.

In the 1929-33 downturn, the first to default were the agricultural exporters: Australia, Argentina, and others in Latin America. The crisis then moved closer to the European core; the common denominator was net debtor status. By May 1931 continental Europe was under acute pressure. Policy responses were vital. By the end of that year, the global economy had taken the key steps toward splitting into three distinct groups:

  • stay the course (keep on the gold standard, but with tariffs)
  • retreat to autarky (government authorisation for any trade transaction)
  • devalue (introduce tariffs but still remain part of the open world trade system)
Those who chose the first option were the ones who could afford to. They were net creditors and were basically quite competitive at the exchange rates prevailing on the cusp of the Great Depression. This was France, Netherlands, Switzerland and a few others, and was known as the ‘gold bloc’.
The ones which suffered the biggest political upheavals in the course of austerity (Germany especially) chose the autarky path. They were also net debtors and imposed capital controls in part to marshal all available foreign exchange for the repayment of sovereign debt.
The rest — a mixture of creditors and debtors — left the gold standard, which means they devalued. They did default, but their defaults were mostly of the form of paying creditors in a depreciated currency.
  • The Devaluation Group (Group 3) performed the best during the rest of the decade. Group 1 (Gold Bloc) performed the worst — their currency was increasingly overvalued with time and their economies uncompetitive. Germany (in Group 2) grew strongly. What Group 2 and 3 had in common was leaving the gold standard; Group 3 stayed plugged into the world economy, Group 2 unplugged.
  • If this story is anything to go by, Club Med are not going to follow the gold bloc route. They can’t afford it. Only Germany and Northern Europe can do that. And they well might, which is bad news for them and for us. Club Med and the Eastern accession members of the EU have to choose between the Autarky and Tariff routes.
  • The devaluations during the Great Depression were an aid to growth. However, what really got the global economy going again was the USA devaluation 1933 and resolute German expansion (also 1933). The Gold Bloc finally joined the party with devaluations in 1935-36, but too tentatively and anyway too late: The US again staged a horrific downturn, when Congress tightened the fiscal position by 2.5 percentage points of GDP, the Fed twice increased the reserve ratio, and the Treasury sterilised gold inflows.
  • Interestingly: the countries which had devalued around 1931 (some earlier, some later) had by 1937 built up such large reserves that they could ride out the US recession by spending down those reserves — no resort to austerity (and almost no devaluations).

This might suggest that in 2010 Club Med won’t go the Gold Bloc route. But this means only that they won’t choose austerity ad infinitum. That doesn’t necessarily mean they go the Group 3 route (devalue and keep trading). The 1931 story suggests that another route would be to stay in EMU and resort (somehow) to pretty massive external barriers. In fact, this is already happening. European banks have consented to restrictions on the disposal of Greek assets on their books. These are capital controls. But Greece (Club Med, really) will also need trade controls. That looks a lot trickier. But who is ready to rule anything out? If the emphasis on “saving the euro” is sufficiently attractive within the EU, then perhaps there can be some countenance of trade controls. Surely the Great Depression teaches us that nothing is off the table when push comes to shove. (It also teaches us that paranoia over upsetting the established monetary order — perhaps especially in Europe? — is one hell of a strong motivator. And, in that episode, was proven to be not only wildly exaggerated but absolutely unhelpful.)

Another key dimension is the role of sort-term capital (mostly cross-border bank deposits and official loans):
  • The retreat of USA short-term private capital from continental Europe from 1928+ undermined their currency pegs to gold. The consensus view is that USA private short-term capital was drawn back by a rising Fed discount rate as the Fed leaned into the stock market boom.
  • The 1931 disturbance travelled from continental Europe to Britain in part because of British losses on credits to those debtors. A similar transmission between Greece and France/Germany is possible today. Which is why, I think, EU needs to set up a TARP/recapitalisation fund for those banks…
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4 Responses to Could summer 2010 reprise summer 1931?

  1. Bruno says:

    What would be the equivalent to today’s Germany in 1931 ? The political cost of shelving the euro-project are I think higher than the cost for individual countries in leaving the gold standard.

    As for austerity, I guess most countries in the OECD world at the moment are treading a fine line between pumping more money in their economy (which is what they should be doing to kick-start their economies – at least if you favour a Keynes-type worldview) and anxiously looking at the markets as to whether the latter will keep financing the spending spree without refinancing costs becoming too prohibitive (fuelled in part by Greece’s problem).

    Why can’t the depreciation of the euro we are currently seeing not continue to allow for the necessary adjustment?

  2. Gwyn says:

    Great Post Scott – although I can’t take it all in!

    I think the political dimension is what’s stopping Member States dropping from the Euro. You can understand why but, come on, it is only one strand of EU policy after all.

    By the way, I’m sure that options to cut States free ARE on the table.

  3. Don says:

    Bruno/Scott, please say more about how depreciation of the Euro might work–and what the counter-forces might be, i.e. Germans not so keen. Also while I agree with Scott that exiting the Euro becomes increasingly plausible for Greece, I wonder how he answers the view that unlike Argentina Greece doesn’t produce enough for export to benefit much from competitive exchange advantage?

  4. Anonymous says:

    Solid observations – the Argentina comparison is also a particularly compelling data point. I can’t help but wonder if Cavallo might not be a little disingenuous with his analysis – if I had a stake in the Argentine economy one of the last things I’d want to see would be competition for investment dollars with a resurgent Club Med decoupled from the Euro.

    This post, the Argentina comparison, and the great depression amnesia post make for a good foundation for an NYT / FT Op-Ed on subject. You know you need to write it.

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